Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 INVESTMENT HORIZON, DURATION, AND MARKET RATE VARIATIONS: FUNCTIONALITY OF THE NEW-ROR Kashi Nath Tiwari Kennesaw State University Abstract Under increasing-rate conditions, the conventional models suggest holding the bond past duration, while under decreasing-rate conditions, these models recommend selling the bond prior to duration to obtain a higher rate of return than that implied by the initial yield to maturity. This appears to be an erroneous result derived from the improper construction of the conventional ROR-models in relation to duration and investment horizon. Under the efficient market hypothesis, it should not matter whether the bond is sold prior to duration or past duration; under all scenarios, the net results should be identical. Only under the conditions of market inefficiency and information asymmetricity, an investor can, intertemporally, gain through the manipulation of the length of the investment horizon. By taking the ratio of value-received and value-paid, this paper constructs an optimal model under which it would not matter whether the bond is held past duration or sold prior to duration. If market rates, on average, remain constant, then the rate of return will be zero; if rates rise, then the investor will experience a negative rate of return; and if market rates fall, then they will experience a positive rate of return. Under the non-averaging procedure of the ratio, even the magnitude of the ROR remains constant over the investment horizon. However, under the ratio-averaging procedure the absolute value of the ROR increases with time such that under falling-rate conditions, the sooner the asset is sold the better, while under rising-rate conditions, the longer the bond is held the better.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 RATCHET OPTIONS Gerald W. Buetow, Jr. James Madison University Abstract This paper develops a general framework for the evaluation of both regular and compound ratchets. The specific model analyzed is for call ratchets since these are the most commonly found in the insurance industry. The results are both intuitive and interesting. As the Cap Rate of the ratchet increases (decreases) both the value of the ratchet and the sensitivity of the ratchet increase (decreases). The fixed income piece of the total portfolio is more influential under a changing interest rate environment. The model is easily extended to price any European type ratchet structure. Future research should concentrate on American and path dependent type ratchets.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 PUBLIC UTILITY COMPANIES: INSTITUTIONAL OWNERSHIP AND THE SHARE PRICE RESPONSE TO NEW EQUITY ISSUES Greg Filbeck University of Toledo Patricia Hatfield Bradley University Abstract The purpose of this study is to investigate the relationship between the level of institutional ownership and the magnitude of the share price response to new equity issues by public utility firms. Previous studies of industrial firms argue that the presence of institutional investors reduces information asymmetry between the issuing firm and the market. Their results indicate that there is a direct relationship between the level of institutional ownership and the resulting magnitude of the share price response. We hypothesize that this relationship is not significant for public utility firms since the role of regulators supersedes that of institutional investors in reducing information asymmetries. Findings, based on a sample of 325 new equity issues by public utilities during 1977-1994, are consistent with our hypothesis.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 THE STATISTICAL DISTRIBUTION OF DAILY EXCHANGE RATE PRICE CHANGES: DEPENDENT VS INDEPENDENT MODELS Ken Johnston Georgia Southern University Elton Scott Florida State University Abstract This study evaluates recently reported, conflicting, models for the probability distributions of daily exchange rate price changes. The conflicting conclusions arise from differing data sets, noncomparable evaluation criteria, and failures to directly compare the candidate models. This study evaluates the mixed jump diffusion model, a discrete mixture of normals distribution model, and four alternative forms of the generalized autoregressive conditional heteroscedastic (GARCH) model. We estimate parameters for each model using maximum likelihood techniques; the goodness-of-fit for the models is measured using Schwarz's criteria. In contrast to some recently published results, none of our autoregressive conditional variance models dominated the others; also none of these models consistently dominated the two models that assume returns are independent. In the cases where there is significant first-order heteroscedasticity in the data set, the GARCH models are superior only 50% of the time. In the most recent subperiod (Jan 88 - Dec 92) tests show that for three of the four currencies the first-order heteroscedasticities are less pronounced than in prior periods. Curiously, first-order GARCH parameters are significant in cases where tests for first-order heteroscedasticity are not significant; this result suggests that our models may be misspecified. Results indicate that independence should not be overlooked, and future research should not focus on the search for the perfect GARCH model, but attempt to develop models that incorporate the pronounced volatility clustering found in exchange rate price series and the independent behavior that exists in the data. These conclusions are consistent with recent findings related to high frequency (intra-daily) returns.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 THE IPO EFFECT AND MEASUREMENT OF RISK John D. Knopf Pace University John L. Teall Pace University Abstract Numerous empirical studies of the well documented IPO underpricing anomaly have employed a variety of different proxies for risk, none of which seem able to explain a significant portion of initial trading day returns. We find evidence that several of the risk proxies used in these studies are outperformed by the Parkinson Extreme Value method in explaining returns to IPOs; hence, these studies seem to have underestimated the explanatory power of uncertainty to predict IPO returns. Nonetheless, we do find evidence in support of the asymmetric information theories of IPO underpricing.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 TACTICAL ASSET ALLOCATION: FOLLOW THE RULE OF 20 Glenn Tanner University of Hawaii This paper has benefited from the comments and assistance of Bill Reichenstein, P.R. Chandy, and Phillip English. A version of this paper was presented at the 1997 Financial Management Association meetings. Abstract The false alarms set off by high market PE ratios in 1995-1996 have motivated many market participants to look for new asset allocation signals. The Rule of 20 appears to be a strong candidate to replace the PE ratio for market watchers. The Rule of 20 is simply a modification of the PE (market PE + annual inflation) that recognizes that PE's should be high in periods of low inflation. This paper examines the forecasting performance of The Rule of 20 relative to the PE ratio. Using a 60-year data set, the R20 measure showed better forecasting performance than the PE for 3-month, 6-month, and 12-month market changes. An experiment performed on a sub-sample of the data suggests that the R20 measure could have been used as a profitable asset allocation tool.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 INTERNATIONAL EVIDENCE ON THE CO-MOVEMENTS BETWEEN BOND YIELDS AND STOCK RETURNS: 1984-1994 A.T. Aburachis Gannon University Richard J. Kish Lehigh University Abstract Forecasting stock returns and bond yields is an important goal of investment management. However, if a random walk process describes stock returns and bond yields, then much of the efforts devoted to forecasting stock returns and bond yields are of questionable value. Research by Fama and French (1996) and others support the hypothesis that stock returns do not follow a pure random walk process. Further support for returns not following a pure random walk is offered by Fleming and Remolona (1997), Clare and Thomas (1992), Campbell and Hamao (1989), and Keim and Stambaugh (1986). These researchers document the predictability of both stock returns and bond yields. Another objective of investment management is the asset allocation process which seeks to develop the mix of assets that provides the optimum risk-return combinations. Surprisingly, little research has been devoted to quantifying the co-movements of stock returns and bond yields, a process useful in the allocation process. The objectives of this research are twofold. First, we offer additional support for the view that stock and bond returns do not follow a pure random walk. Secondly, we quantify the relationship between stock returns and bond yields for nine industrial countries during the period 1984-1994.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 THE IMPACT OF A PRICE CUT ON NET INCOME AND PROFIT MARGIN Dongsae Cho Quinnipiac College Abstract A reduction in the price of a product may improve the profit for the stockholders due to more demand for the same product. In this paper, three guidelines are offered to practitioners who are considering a price cut. First, a price reduction is justified only if the price elasticity of demand is less than a benchmark value, which is derived in this article. Second, there exists the optimum level of price cut, which maximizes the stockholders' wealth. Third, a declined profit margin after a price cut does not necessarily impair the stockholders' wealth.

Journal of Financial and Strategic Decisions Volume 12, Number 2   Fall 1999 LOGIT ANALYSIS OF THE EMPLOYEE CLASSIFICATION PROBLEM FOR TAX PURPOSES Woodrow W. Cushing University of Minnesota-Duluth Nestor M. Arguea University of West Florida Universidad Complutense de Madrid Abstract This study undertakes the task of simplifying the complex problem of classifying workers as either an employee or an independent contractor for income tax withholding purposes. Historically, the Internal Revenue Service has relied on twenty common law factors to determine whether a worker in a given context is an employee or an independent contractor. Logistic regression is used to estimate the parameters of a model using data obtained from Private Letter Rulings from 1988 through a portion of 1993. The model is highly accurate in correctly classifying workers as either employee or independent contractor. The final model is successful relying on only five of the twenty common law factors. The most important variables are whether the employer has the right to require either oral or written reports, set the hours of work, and whether the worker can earn a profit or sustain a loss. These findings are robust for each of the years in the study. Using five independent variables, the model has an prediction accuracy rate of 98.5 percent using sample data. An out-of-sample test was performed and the overall accuracy rate was 94.7 percent. The model possesses excellent predictive abilities both within sample and without.

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