Market Rate Of Return Research Articles

Portfolio Decisions of Older American Workers: The Role of Private Pensions

With a large proportion of the USA population getting closer to retirement age, it is necessary to ensure the security of the retirement wealth for this old generation. In order to do so, it is important to understand not only how much wealth older workers hold, but also how they hold it. This research is one of the first studies to investigate the effect of pension type on older workers' asset allocation decisions. After the pension type transition, from Defined Benefit (DB) to Defined Contribution (DC) plans, stock market risk has been transferred from firms to individuals, in the sense that older workers with DC pensions are more exposed to the risk in the financial market return rate. Since the beginning of 2000, the US stock market has sharply declined, which has directly influenced the value of retirement assets, namely the value of DC pension plans, given many DC pension accounts were invested in the financial market. As a result, this stock market failure might then cause unexpected insufficiency in the retirement wealth for those with DC pensions. My hypothesis is that people with different types of pensions will allocate their non-pension wealth differently according to their pension type. Specifically, older workers with DC pensions might have already adjusted their asset allocation in such a way that they will have enough to maintain their standard of living, even when the market return is low and their pension values are reduced. In this study, I first present a theoretical model in a dynamic setting, in which the asset allocation decisions are endogenously determined. Then, I use the data from all available waves of the Health and Retirement Study (HRS), a panel survey of retirement age respondents and their spouses, from 1992 to the present, to perform the empirical analysis. The empirical work studies the effect of pension type on asset allocation by comparing the non-pension wealth portfolio choices of older workers with DB pensions and of those with DC pensions. Preliminary results show that pension type does have an effect on people's asset allocation decisions, which might be informative to policy makers in the debate on Social Security privatization.

A Generalized Approach to Multigeneration Project Evaluation

1. IntroductionIt is well-known that the choice of discount rate plays a significant role in the ranking of projects with varying time paths of costs and benefits. For public projects, the choice of the appropriate social discount rate (SDR) is not clear-cut even in the context of short-lived projects in which costs and benefits occur within a single generation. In particular, when capital taxes produce a wedge between gross and net rates of return, should one discount at the economy's rate of return (the before tax rate) or the individual's rate of return (the after tax rate)? In the single-generation context, the literature falls in two camps.1 One camp argues that the appropriate SDR is a weighted average of the gross and net rates of return with weights typically determined by the fractions of resources drawn from consumption and private investment, respectively.2 A second camp argues that future benefits should be discounted at the net rate of return, but that the initial investment should be multiplied by a scale factor so that the direct costs of the project can be expressed in terms of consumption units.3Both approaches suffer from severe implementation problems. For the first approach, there is no general formula for the weights needed to calculate the SDR as a weighted average of two market rates of return (Dreze 1974). Indeed, the appropriate SDR to use is project-specific (Stiglitz 1982). Without a systematic methodology to derive project specific SDRs, the weighted average approach is hard to implement. For the second approach, which equalizes the SDR to the net rate of return, the scale factor--the opportunity cost of public investment--must be quantified. The opportunity cost of public investment depends on whether resources come from private investment or consumption and on the calculation of the present value of the future consumption yielded by a unit of capital discounted at the net rate of return; that is, the shadow price of capital. As Lind (1997) points out, however, there is no general agreement on a specific procedure for calculating the shadow price of capital. Indeed, the concept of the opportunity cost of public investment suffers the same project dependence problem as the first view of the SDR (Diamond 1968).Multigeneration projects such as nuclear waste disposal, natural resource conservation, or even Social Security reform further complicate discount rate choice. Specifically, intergenerational equity, in addition to intertemporal efficiency, plays a role in determining the appropriate social discount rate for multigeneration public project evaluation.4 As in the single-generation context, there are two competing views on the appropriate discount rate when evaluating multigeneration projects: the descriptive and the prescriptive approaches.5The descriptive approach to discounting is a market-based approach. It does not rely on an explicit social welfare function (SWF) or the pure time preference rate embedded in the SWF. However, the descriptive approach works under the assumption that intergenerational compensation through changes in the tax/debt policy is available.6 It is argued that, under appropriate intergenerational compensation, the market rates of return are still relevant for calculating the SDR for multigeneration project evaluation, and, in general, the SDR should be a weighted average of the gross and net rates of return. This descriptive view of setting the SDR equal to the market return appears to underlie the Office of Management and Budget's (OMB) adoption of 7% as the appropriate discount rate for federal programs.7The intent of the prescriptive approach is to use the social discount rate as an expression of ethical judgment on how consumption of future generations should be compared to consumption of current generations. …

Predator-Prey: An Efficient-Markets Model of Stock Market Bubbles and the Business Cycle

This paper develops a microeconomic model of the business cycle, based on the classical Lotka-Volterra predator-prey dynamic system, in which agency costs play the role of the predatory activity. The result is a system where producers (i.e., managers, workers and all those in direct, hands-on contact with production) gradually gain control of the productive process when the times are good, and use this control to enhance their own well-being at the expense of the investors (thus increasing agency costs) until this depredation drives the system into a crisis that leads the investors to tighten their bureaucratic controls on the producers, which eventually brings the system back to the growth path. The model is compatible with the Efficient Markets Hypothesis, and therefore the resulting cycle is fully discounted by the investors out of the future expected path but, as the market rate of return is assumed to be distributed according to a Wiener diffusion process, the key variables are subject to a geometric Brownian perturbation and thus the growth rate we should expect to observe in the direct analysis of a sufficiently long time series is the median path, not the mean - whereas the market discounts the future impact of the cycle from the mean (i.e., the expected) path, not the median. The resulting model also predicts that stock market valuations would present instances of bubbles and crashes more or less synchronised with the Business Cycle, without this implying any irrational behaviour on the part of the investors. Based on a preliminary analysis of the features of this model against well-known stylised facts, this paper suggests that it may be able to perform better against empirical validation than the Real Business Cycle model. This paper represents a revised version of the one previously published in SSRN under the title Predator-Prey: An Efficient-Markets Model of the Business Cycle.

On a Simple Econometric Approach for Utility-Based Asset Pricing Model

The Journal of Finance has published an important paper entitled “A Simple Econometric Approach for Utility-Based Asset Pricing Model” by Brown and Gibbon (1985). The main purpose of this paper is to extend the research of Brown and Gibbons (1985) and Karson, Cheng and Lee (1995) in estimating the relative risk aversion (RRA) parameter β in utility-based asset pricing model. First, we review the distributions of RRA parameter estimate \(\hat \beta \). Then, a new method to the distribution of \(\hat \beta \) is derived, and a Bayesian approach for the inference of β is proposed. Finally, empirical results are presented by using market rate of return and riskless rate data during the period December 1925 through December 2001.

A Canonical Correlation Analysis of CEO Compensation and Corporate Performance in the Service Industry

This paper attempts to examine a canonical (simultaneous) relationship between service industry CEOs' compensation and corporate performance with respect to accounting‐based and market‐based performance measures. In addition, this study examines the effect of firm size on compensation. The results of this study suggest that executive compensation depends simultaneously on both market‐based and accounting‐based performance measures. EPS, ROA, ROE and Market Rate of Return are positively associated with both cash compensation and long‐term compensation. Firm size is also positively related to the long‐term compensation.

Simplified Discounting Rules in Binomial Models

In capital budgeting it is common practice to discount expected cash flows with a constant risk adjusted discount rate. This discount rate often is derived on the basis of the capital asset pricing model. Within this paper sufficient conditions for supporting this discounting rule will be reviewed and its relation to option pricing theory will be clarified. The analysis is based on a joint binomial model for cash flows and market rates of return. The results show that if the analysis is based on a joint binomial model, the restrictive assumptions of the capital asset pricing model can be relaxed.

The Multiple Bottom Lines of Corporate Citizenship: Social Investing, Reputation, and Responsibility Audits

Corporate citizenship, that is, company practice that impacts various stakeholders, is increasingly being assessed along multiple bottom lines. Increasingly, executives need to be aware of the ways in which their corporate practices are monitored externally, as well as undertaking internal reviews that can improve performance. This paper highlights the trends in assessing citizenship. There are, for example, four relevant types of social investing, which evaluate citizenship in multiple ways. In the most common, investment houses/researchers develop screens on company practices for interested social investors. Alternatively, activist shareholders monitor corporate practice in areas of concern and use shareholder resolutions to foster change. Some investors are willing to commit financial resources to development of disadvantaged areas with expectations of market or less than market rates of return. The fourth type of social investing involves funding either micro ventures or small-to-mid-sized ventures either in disadvantaged areas or for proactive social gains, sometimes using corporate philanthropic resources to do so. In addition, dimensions of reputation are rated by researchers and magazines for specific groups or for overall corporate reputation. Companies that wish to improve

Security Returns and the Value Relevance of Accounting Data

INTRODUCTION Empirical market-based accounting research seeks evidence of the value relevance of accounting data via analysis of the relation between these data and various market variables. The decade of the 1990s witnessed an increasing use of price per share and market rate of return as the market variables of interest. The focus of this commentary is on regressions of price per share on the levels of various financial statement data (referred to herein as “price-levels regressions”) and regressions of returns on changes in these financial statement variables (referred to herein as “returns regressions”). The main points in the commentary are:

Stock Price Reactions to Securities Recommended in Business Week's “Inside Wall Street”

AbstractThe price behavior of stocks of firms that were favorably mentioned in the “Inside Wall Street” column in Business Week are studied. These firms have been the subject of rumors or have been recommended by analysts or brokerage houses and, therefore, their mention in Business Week constitutes dissemination of secondary information. Positive, significant excess returns are observed the day prior to the publication date, the publication date, and the two days after publication. Positive, significant excess returns are observed for long‐term holding periods prior to the publication date, while negative, significant excess returns are observed for the post‐publication holding periods. The observations appear to be consistent with the price performance of firms that might have been subject of either rumors or recent recom‐mendations by analysts or brokerage houses. The results suggest that secondary information is of value only to low transaction cost, short‐term traders. Investors who buy for the longer term based on secondary information generally receive below market rates of return.

Sampling distribution of the relative risk aversion estimator: Theory and applications

Brown and Gibbons (1985) developed a theory of relative risk aversion estimation in terms of average market rates of return and the variance of market rates of return. However, the exact sampling distributions of the relative risk aversion estimators have not been derived. The main purpose of this paper is to derive the exact sampling distribution of an appropriate relative risk aversion estimator. First, we have derived theoretically the density of Brown and Gibbons' maximum likelihood estimator. It is shown that the centralt is not appropriate for testing the significance of estimated relative risk aversion distribution. Then we derived the minimum variance unbiased estimator by a linear transformation of the Brown and Gibbons' maximum likelihood estimator. The density function is neither a central nor a noncentralt distribution. The density function of this new distribution has been tabulated. There is an empirical example to illustrate the application of this new sampling distribution.

The Growth Illusion: The P/E ‘Cost’ of Earnings Growth

It is intuitively tempting to view firms with high earnings growth as offering special value. Indeed, standard dividend discount models seem to equate price growth with earnings growth. But a firm can show substantial earnings growth-by increasing earnings retention, for example, or reinvesting at available market rates-without creating a single dollar of extra value for shareholders. The significance of realized earnings growth becomes apparent only after one has determined the baseline level of PIE growth (or decline) consistent with the firm's initial prospects and valuation. One must then examine carefully the firm's franchise opportunities-its ability to invest in lines of business that offer more than the market rate of return. The firm's current earnings growth may be in relation to the market average, yet not excessive at all given its expected franchise opportunities. High earnings that derive from franchise opportunities already embedded in the firm's PIE reflect management's exploitation of preexisting opportunities. In effect, this exploitation represents a drawdown of the franchise value incorporated in PIE and suggests an inverse relation between realized earnings growth and realized PIE. Only if management has the skill or luck to extend the firm's franchise opportunities beyond those already embedded in the firm's valuation will excess earnings growth represent added value to shareholders.

Strategic Use of Pension Funds Since 1978

Through their pension funds, workers own, but do not control, most of the finance capital in the United States. Since 1978 the U.S. labor movement's defensive and offensive pension strategies have bolstered union bargaining power and provided funds to profitable and union-only construction projects. However, the role of unions in the U.S. industrial relations system, the structure of pension management and the competing uses of pension funds stymie labor's efforts to control pension funds. Moreover, labor's reliance on property rights and the market rate of return (to identify worthy projects) may, over time, contravene other labor goals. Challenging how finance capital is invested, rather than who owns the capital, is a strategy the labor movement should begin to consider.

Aggregate Earnings Expectations and Stock Market Behavior

The paper examines the degree of association between cross-sectional aggregate measures of earnings forecasts and the market rate of return. Various measures of “market” earnings forecasts are devised. The results indicate that while changes in earnings forecasts of individual companies are correlated with the price behavior of the respective stocks, very weak association exists between the aggregate measure of earnings forecasts and the market rate of return. This lack of association (which suggests that information on aggregate changes in earnings forecasts is not very useful to investors) is due primarily to the very low commonality in the revisions of earnings forecasts across companies.

THE EFFICIENCY OF WATER PRICING: A RATE OF RETURN ANALYSIS FOR MUNICIPAL WATER DEPARTMENTS1

ABSTRACT: The rate of return on invested capital can be used as a guide to resource allocation by municipal water departments (MWD's) in the same way it is used in the private sector. To achieve economic efficiency, the target rate of return for MWD's should be the market rate of return as an approximation to the opportunity cost of capital. The actual internal rate of return for a sample of 30 California MWD's for the period 1970‐1982 is calculated for this study. The operating internal rate of return varies across the sample MWD's from less than 2 percent to 14 percent. If 10 percent is taken as the opportunity cost of capital, 25 of the 30 MWD's were inefficient; i.e., earned less than 10 percent. Half the sample earned less than 5 percent. An examination of potential causes of low rates of return shows that low average water prices are the primary reason for the low rates of return. For efficient operation, MWD's should set a target rate of return equal to the opportunity cost of capital and adjust water prices so as to achieve that target.

Consumer Welfare and Inefficiency Among Regulated Industries

While the issue of efficiency on the side of production is still not a settled question, it is generally agreed that competition is more conductive to efficiency—both allocative and X—than monopoly. When the monopoly is regulated, i.e., receiving a rate of return less than it would if left unregulated but greater than the market rate of return, both allocative and X‐inefficiency result. Since the degree of inefficiency amounts to a tax on consumers, the question of inefficiency in production has a twin companion in the form of consumer welfare losses. This is particularly true for many public utilities upon which low income families spend a large proportion of their income. The quasi tax that the regulated monopolist exacts neither generates a flow of public goods nor increases returns to shareholders. It is a particularly burdensome levy because the rate structure is highly regressive.

Conservation Using a Rate of Return Decision Rule: Some Examples from California Municipal Water Departments

A significant alternative to physical rationing of water to achieve conservation is provided by the price system. To act like profit maximizing firms, municipal water utilities (MWD's) should price their water so as to earn the opportunity cost of capital (the market rate of return) on the assets. The actual internal rate of return is calculated for a sample of 30 California MWD's for a 12‐year period. For the 26 MWD's with a rate of return less than 10%, iterative simulations are run with increases in the MWD's average price to achieve the target rate of return. The magnitude of water conservation using the rate of return rule is reported for three alternative price elasticities of demand. The new implicit prices necessary to achieve the target rate of return are shown to be less than the cost of the cheapest new surface supply.

Random coefficient and errors-in-variables models for beta estimates: Methods and applications

Based upon both theoretical and empirical arguments, the market model has been specified as a random coefficient and errors-in-variables (RCEV) rates of return generating process. The impacts of measurement errors associated with market rates of return and the risk-free on the estimated beta coefficient and estimated random coefficient parameters are analyzed in detail. It is shown that the beta coefficient obtained from RCEV can be decomposed into a) true component, b) bias due to measurement errors, c) bias due to specification error, and d) interaction bias.

The Irrelevance of Capital Structure for the Impact of Inflation on Investment

ABSTRACTStudies concerning the effect of inflation on firms' investment decisions suggest that the form of financing is relevant in assessing the effect of inflation on investment. This paper demonstrates that when the equilibrium relationship between market rates of return on bonds and stocks is considered, the effect of inflation on investment is independent of the capital structure. The paper also shows that when the ‘Fisher effect’ is assumed to hold, the cut‐off rate of return on investment declines with anticipated inflation independently of the financing. However, if the real interest rate rises with inflation, inflation may increase the cut‐off rate.

Taxation and Real Cost of Capital

The effects of inflation, via taxes, on the firm's cost of capital are analyzed. The taxes are the corporate income tax and household taxes on dividends and capital gains. The costs of equity and debt are taken at their nominal values as observed by the firm on the capital market. The net real cost of capital, where market rates of return are adjusted for inflation, are analyzed. The net effects of inflation on capital cost can thus be determined, while recognizing several counteracting tendencies which operate through the tax system. It turns out that for most reasonable assumptions, real capital cost will fall as a result of inflation when both profit tax and taxes on dividends and capital gains are taken into account. Different ways of indexing the system of taxation to insulate it from inflationary distortions are also presented. I. The Problem This study deals with profit taxation of the business sector and income taxation of the household sector. The central concept is the cost of capital and our intention is to analyze in detail the effects of taxation on capital cost in times of inflation. When there is inflation, the tax system produces distortions because not all real costs are deductible for taxation and not all real income is included in taxable profits. Costs of debt and equity also become distorted. Under the tax regimes which exist in most countries, four different distorting factors operate in times of inflation. Two of them are due to the way the system of corporate profit taxation is constructed (points 1 and 2 below) and two to income taxation of households (points 3 and 4 below). 1. When depreciation allowances are based on historical costs under corporate tax laws, inflation undermines their real significance. As a result, part of capital consumption may be included in the tax base (or accelerated

Immunization of Pension Funds and Sensitivity to Actuarial Assumptions: Comment

A recent article by Keintz and Stickney (K-S) [5] outlines a bond duration method for immunizing pension plans from market rate risk. The authors show how unexpected alterations in market rates of return can cause offsetting changes in pension assets and liabilities. By employing Macaulay's bond duration formula, K-S demonstrate how these opposing balance sheet changes may protect a pension plan from random market rate movements. Their research should prove quite useful in managing pension funds where the investment instruments have known maturities. Some pension plans, though, may desire to invest in corporate bonds where call features could alter maturity structure unexpectedly. K-S raise the issue of the effect corporate bonds with callable features could have on duration. The K-S technique relies to some extent on the pension manager matching the maturity structure of investment assets with fund liabilities.' A call provision allows the borrower to redeem bonds before maturity and thus may impose uncertainty on the length of the asset holding period. Many corporate bond issues will include call privileges which permit early redemption.2 Ostensibly the purpose of the call feature is to provide the corporation with the chance to refinance their bonds when interest rates are lower than when the bonds were originally issued. A bond call provision subjects the investor to the risk of redemption at a time of low interest, thus reducing overall investment yield and uncertainty as to when bond proceeds are payable. Most investors protect against this type of interest rate risk by requiring a higher yield on callable issues. However, the uncertainty with respect to maturity structure of callable issues is one over which the investor has little control. Figure 1 depicts the type of situation faced by the investor in callable securities. Condition A prevails as long as market interest rates during the call period are above the effective yield on the bond. Condition B necessitates