Tax-Timing Options and the Demand for Idiosyncratic Volatility

37 Pages Posted: 4 Apr 2017

See all articles by Oliver Boguth

Oliver Boguth

Arizona State University (ASU) - Finance Department

Luke C.D. Stein

Arizona State University (ASU) - Finance Department

Date Written: April 3, 2017

Abstract

Investors have a choice over when to incur taxes on individual investments, and typically benefit from delaying the realization of capital gains while harvesting losses. This option implies that the effective tax rate on capital losses exceeds the one on capital gains, resulting in a convex after-tax payoff. Convexity creates a demand for idiosyncratic volatility (IVOL) within a well-diversified portfolio, and can therefore explain the puzzling negative relation between IVOL and expected stock returns. A simple model with tax-timing options predicts that the demand for idiosyncratic volatility increases with the tax rate, the nominal interest rate, and unrealized capital gains, and we show that all three measures predict the IVOL premium in the time-series. In the cross-section, we show that the magnitude of the IVOL premium increases with investors’ average tax exposure.

Keywords: Demand for idiosyncratic volatility, idiosyncratic volatility puzzle, tax-timing options, tax loss harvesting, investment taxes, capital losses

JEL Classification: G10, G11, G12

Suggested Citation

Boguth, Oliver and Stein, Luke C.D., Tax-Timing Options and the Demand for Idiosyncratic Volatility (April 3, 2017). Available at SSRN: https://ssrn.com/abstract=2945779 or http://dx.doi.org/10.2139/ssrn.2945779

Oliver Boguth (Contact Author)

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Luke C.D. Stein

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States
480-965-9412 (Phone)
480-965-8539 (Fax)

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

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