Equilibrium pricing of special bearer bonds

Abstract

On 1981, the government issued Special Bearer Bonds under a scheme which allowed people to invest their black money in these bonds and enjoy freedom from investigations and prosecutions for tax evasion in respect of their holdings of these bonds. Though these bonds are no longer available on tap, there is an active secondary market for these bonds; the complete anonymity of these bearer bonds has helped to make them quite liquid. This paper derives equilibrium prices of these bonds in the secondary market. The entire analysis is carried out in a continuous time framework using the mixed Wiener-Poisson process; the Capital Asset Pricing Model (CAPM) is employed in a modified form which accounts for the fact that, for black money investors, investment in any asset other than the bearer bond involves the risk of tax penalties in addition to the usual investment risks. The existence of the bearer bond helps to analyze the impact of black money on the capital market in general; in this setting it is shown that the pricing of risky assets relative to each other and relative to the white risk free bonds is unaffected bythe presence of black money. This provides justificaiton for using the CAPM is corporate finance and portfolio management in a capital market like India where black money is widespread. Our results can be useful for estimating the magnitude of black money and the degree of tax enforcement; it can also help the Government in pricing any fresh issues of such bonds in future