Simple Intuition Gone Awry: Combining Real and Financial Options in Tax Elections

47 Pages Posted: 20 Mar 2012 Last revised: 19 Dec 2013

See all articles by David C. Brown

David C. Brown

University of Arizona - Department of Finance

J. Chris Leach

University of Colorado at Boulder - Department of Finance

Date Written: December 19, 2013

Abstract

Taking reversible tax elections as a motivation, we analyze optimal initiation of a zero-cost, stochastic-strike-price financial option with a fixed expiration date. For such contexts, the real option to delay initiation to exploit favorable movement in the strike price should be weighed against the receipt of a shorter-lived option. Simple option time-value intuition, although commonplace in practitioner discussions, can be misleading. Calibrations suggest that suboptimal exercise can deplete after-tax value by 10%, resulting in billions of dollars of higher tax payments. We introduce corrective intuition by analyzing a discrete-time Markov process, and for practical purposes, provide an alternative heuristic strategy.

Keywords: Options, Real Options, Tax, Stochastic Control, Roth IRA

JEL Classification: G1, H2

Suggested Citation

Brown, David C. and Leach, J. Chris, Simple Intuition Gone Awry: Combining Real and Financial Options in Tax Elections (December 19, 2013). Available at SSRN: https://ssrn.com/abstract=2023857 or http://dx.doi.org/10.2139/ssrn.2023857

David C. Brown (Contact Author)

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States
520-626-0746 (Phone)

HOME PAGE: http://www.davidclaytonbrown.com

J. Chris Leach

University of Colorado at Boulder - Department of Finance ( email )

Campus Box 419
Boulder, CO 80309-0419
United States
303-492-5665 (Phone)
303-492-5962 (Fax)

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