Optimal dynamic asset allocation with capital gains taxes and stochastic volatility

This paper investigates the effect of capital gains tax on investors' optimal dynamic consumption and portfolio choice when there is predictable variation in return volatility. For conservative investors who are under the leverage effect of a capital gains tax, we assume a negative after-tax leverage effect on the intertemporal hedging demand caused by pure changes in stochastic volatility. As a result, negative correlation between the unexpected return on the stock and its stochastic volatility is expected. Moreover, in a bad market accompanied by high volatility under the leverage effect, a conservative investor will be subject to a negative vega effect of the tax option on the intertemporal hedging demand coming from pure changes in stochastic volatility.