Two Stock Portfolio Choice with Capital Gain Taxes and Short Sales

McCombs School of Business Finance Working Paper

47 Pages Posted: 25 Jun 2001

See all articles by Michael F. Gallmeyer

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Stathis Tompaidis

University of Texas at Austin - McCombs School of Business

Date Written: June 2001

Abstract

In this paper, we study the consumption-portfolio problem of an investor who faces realized capital gain taxes in a two stock setting with short sales. The investor finances consumption and a time of death bequest by trading in a money market and two stocks that he can short sell subject to margin constraints and a shorting the box restriction. When the correlation between the two stocks is low, the investor's optimal strategy is similar to the case of one risky asset with the notable exceptions that the investor may optimally hold an undiversified equity position. At higher levels of correlation, tax trading costs lead to significantly different trading strategies. With short sale restrictions, it is common for the investor to hold an undiversified equity portfolio. With short selling, the trading strategy is dramatically different. The investor is induced to short equity under two different incentives. The first incentive is an imperfect form of shorting the box used to reduce the aggregate equity exposure while the second incentive is a trading flexibility strategy. Under the trading flexibility incentive, the investor shorts stock while holding a positive aggregate equity position even when the current portfolio has no embedded gains. By doing so, the investor uses the tax loss selling option embedded in the short position to offset gains in the larger long stock position when rebalancing. This trading flexibility incentive also leads to the investor holding less equity when older in contrast to the two stock case with no short sales and the previously studied one stock case.

Keywords: Taxes, Multiple Assets, Short Sales, Capital Gains, Portfolio Selection, CRRA, Shorting the box

JEL Classification: G11, H20

Suggested Citation

Gallmeyer, Michael F. and Kaniel, Ron and Tompaidis, Stathis, Two Stock Portfolio Choice with Capital Gain Taxes and Short Sales (June 2001). McCombs School of Business Finance Working Paper. Available at SSRN: https://ssrn.com/abstract=274795 or http://dx.doi.org/10.2139/ssrn.274795

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

Ron Kaniel (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

London
United Kingdom

Stathis Tompaidis

University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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