Abstracts - Financial Services Review

Abstracts:

Financial Services Review
Volume 6 Number 1, 1996

THE IMPACT OF INFLATION ON ROE, GROWTH AND STOCK PRICES
(pp. 1-17) DOWNLOAD FULL-TEXT ARTICLE
Frank K. Reilly

ABSTRACT
Using the constant growth dividend discount model (DDM), it can be shown that the critical factor which determines whether common stocks will be able to be an inflation hedge is the growth rate of dividends. In turn, the growth of dividends is mainly impacted by the aggregate return on equity (ROE). Using the DuPont formula it is clear that the main variable that drives the aggregate ROE is an inflationary environment is the profit margin. Following from this background, this article updates and extends an earlier analysis that involves an analysis of ROE and its components for the 40-year period 1956-1995. The analysis demonstrates that the aggregate ROE is currently at about the same level as in the 1960's, but the components have changes - i.e., there has been a decline in total asset turnover and profit margin, but a significant increase in financial leverage that has compensated for the declines in turnover and profit margin. It is further shown that there have been periods of high and low inflation since 1956 and the negative impact of inflation on the implied growth rate is confirmed, which helps explain why investigators find consistent empirical results that common stock are poor inflation hedges.

THE CONGRESSIONAL CALENDAR AND STOCK MARKET PERFORMANCE
(pp. 19-25) DOWNLOAD FULL-TEXT ARTICLE
Reinhold P. Lamb, K.C. Ma, R. Daniel Pace, William F. Kennedy

ABSTRACT
This study reports on the existence of a curious calendar effect - a relationship between stock market performance and the schedule of the United States Congress. Almost the entire advance in the market since 1897 corresponds to the periods when Congress is in recess. This is an impressive result, given that Congress is in recess about half as long as in session. Furthermore, average daily returns when Congress is not meeting are almost eight times greater than when Congress is in session. Throughout the year, cumulative returns during recess are thirteen times that experienced while Congress is in session.

SHORT SELLING AND TRADING ABUSES ON NASDAQ
(pp. 27-39) DOWNLOAD FULL-TEXT ARTICLE
Timothy R. Smaby, Robert L. Albert Jr., H. David Robison

ABSTRACT
We examine the potential for short-selling trading abuses unique to Nasdaq during a period when there was no up-tick rule and no effective prohibitions against "naked" short selling. We find that (1) short sellers earned significant abnormal returns on Nasdaq securities, but these were smaller than on NYSE/AMEX securities; (2) they did not destabilize markets by selling into falling markets and exacerbating price drops; and (3) Nasdaq short sellers may be more susceptible than MYSE/AMEX shorts to "short squeezes". Our results cast doubt on the appropriateness of recent regulatory reforms established for Nasdaq and public concern over Nasdaq short-selling abuses.

FINANCIAL PLANNING AND COLLEGE SAVINGS RECOMMENDATIONS: LET'S SET THINGS STRAIGHT
(pp. 41-52) DOWNLOAD FULL-TEXT ARTICLE
Thomas H. Eyssell

ABSTRACT
Continuing increases in the cost of higher education, along with an ever-changing financial aid environment, suggest that financial planning is more important than ever for those seeking to send a child to college. One commonly used aid to the financial planner is the "college savings table", which is ubiquitous in both the popular press, as well as the literature geared toward financial planners. Although they are intended to simplify the planning process, some of these tables may lead to misallocation of family resources. The tables generally purport to show how much money parents must save monthly to fund four years of college at a specified future date. We demonstrate that these tables often employ flawed methodology. Upon correction (and given reasonable assumptions abut investor behavior, growth rates in tuition costs, and investment yields), the monthly savings necessary to fund a given level of college expenses can be substantially less than those reported.. Additionally, published tables typically provide the planner with a limited range of investment yield assumptions, suggesting a narrow range of portfolio possibilities. We provide a series of tables which allow the financial planner to estimate required savings for various combinations of investment yields and tuition growth rates.

ADVERSE SELECTION, SEARCH COSTS AND STICKY CREDIT CARD RATES
(pp. 53-67) DOWNLOAD FULL-TEXT ARTICLE
O. Felix Ayadi

ABSTRACT
Several scholars of financial economics observed that during the 1980s, market interest rates declined continuously with little or no impact on credit card rates. Recently, Meyercord (1994), Sinkey and Nash(1993) and Sullivan and Worden (1995) recorded significant changes in the credit card market indicating an increased level of competition. This study represents an attempt to determine the sensitivity of credit card rates to the costs of funds in the U.S. economy. The evidence from the Johansen Cointegration test confirms that credit card rates and cost of funds possess a long-run equilibrium relationship with one another. Furthermore, the results of the error correction models are indicative of a sluggish rate at which credit card interest rates adjust to the costs of funds. Between 1982 and 1994, credit card rates adjust to changes in the cost of funds at about 15 percent per quarter. These results represent anecdotal evidence for the validity of adverse selection, search and switch costs explanations that have been discussed in the financial contracting literature.


THE JOURNAL OF INDIVIDUAL FINANCIAL MANAGEMENT
*Abstracts:* Financial Services Review Volume 6 Number 1, 1996 THE IMPACT OF INFLATION ON ROE, GROWTH AND STOCK PRICES (pp. 1-17) DOWNLOAD FULL-TEXT ARTICLE Frank K. Reilly ABSTRACT Using the constant growth dividend discount model (DDM), it can be shown that the critical factor which determines whether common stocks will be able to be an inflation hedge is the growth rate of dividends. In turn, the growth of dividends is mainly impacted by the aggregate return on equity (ROE). Using the DuPont formula it is clear that the main variable that drives the aggregate ROE is an inflationary environment is the profit margin. Following from this background, this article updates and extends an earlier analysis that involves an analysis of ROE and its components for the 40-year period 1956-1995. The analysis demonstrates that the aggregate ROE is currently at about the same level as in the 1960's, but the components have changes - i.e., there has been a decline in total asset turnover and profit margin, but a significant increase in financial leverage that has compensated for the declines in turnover and profit margin. It is further shown that there have been periods of high and low inflation since 1956 and the negative impact of inflation on the implied growth rate is confirmed, which helps explain why investigators find consistent empirical results that common stock are poor inflation hedges. THE CONGRESSIONAL CALENDAR AND STOCK MARKET PERFORMANCE (pp. 19-25) DOWNLOAD FULL-TEXT ARTICLE Reinhold P. Lamb, K.C. Ma, R. Daniel Pace, William F. Kennedy ABSTRACT This study reports on the existence of a curious calendar effect - a relationship between stock market performance and the schedule of the United States Congress. Almost the entire advance in the market since 1897 corresponds to the periods when Congress is in recess. This is an impressive result, given that Congress is in recess about half as long as in session. Furthermore, average daily returns when Congress is not meeting are almost eight times greater than when Congress is in session. Throughout the year, cumulative returns during recess are thirteen times that experienced while Congress is in session. SHORT SELLING AND TRADING ABUSES ON NASDAQ (pp. 27-39) DOWNLOAD FULL-TEXT ARTICLE Timothy R. Smaby, Robert L. Albert Jr., H. David Robison ABSTRACT We examine the potential for short-selling trading abuses unique to Nasdaq during a period when there was no up-tick rule and no effective prohibitions against "naked" short selling. We find that (1) short sellers earned significant abnormal returns on Nasdaq securities, but these were smaller than on NYSE/AMEX securities; (2) they did not destabilize markets by selling into falling markets and exacerbating price drops; and (3) Nasdaq short sellers may be more susceptible than MYSE/AMEX shorts to "short squeezes". Our results cast doubt on the appropriateness of recent regulatory reforms established for Nasdaq and public concern over Nasdaq short-selling abuses. FINANCIAL PLANNING AND COLLEGE SAVINGS RECOMMENDATIONS: LET'S SET THINGS STRAIGHT (pp. 41-52) DOWNLOAD FULL-TEXT ARTICLE Thomas H. Eyssell ABSTRACT Continuing increases in the cost of higher education, along with an ever-changing financial aid environment, suggest that financial planning is more important than ever for those seeking to send a child to college. One commonly used aid to the financial planner is the "college savings table", which is ubiquitous in both the popular press, as well as the literature geared toward financial planners. Although they are intended to simplify the planning process, some of these tables may lead to misallocation of family resources. The tables generally purport to show how much money parents must save monthly to fund four years of college at a specified future date. We demonstrate that these tables often employ flawed methodology. Upon correction (and given reasonable assumptions abut investor behavior, growth rates in tuition costs, and investment yields), the monthly savings necessary to fund a given level of college expenses can be substantially less than those reported.. Additionally, published tables typically provide the planner with a limited range of investment yield assumptions, suggesting a narrow range of portfolio possibilities. We provide a series of tables which allow the financial planner to estimate required savings for various combinations of investment yields and tuition growth rates. ADVERSE SELECTION, SEARCH COSTS AND STICKY CREDIT CARD RATES (pp. 53-67) DOWNLOAD FULL-TEXT ARTICLE O. Felix Ayadi ABSTRACT Several scholars of financial economics observed that during the 1980s, market interest rates declined continuously with little or no impact on credit card rates. Recently, Meyercord (1994), Sinkey and Nash(1993) and Sullivan and Worden (1995) recorded significant changes in the credit card market indicating an increased level of competition. This study represents an attempt to determine the sensitivity of credit card rates to the costs of funds in the U.S. economy. The evidence from the Johansen Cointegration test confirms that credit card rates and cost of funds possess a long-run equilibrium relationship with one another. Furthermore, the results of the error correction models are indicative of a sluggish rate at which credit card interest rates adjust to the costs of funds. Between 1982 and 1994, credit card rates adjust to changes in the cost of funds at about 15 percent per quarter. These results represent anecdotal evidence for the validity of adverse selection, search and switch costs explanations that have been discussed in the financial contracting literature.