The Underinvestment Problem, Risk Management and Corporate Earnings Retention

-- Stanley C W Salvary

This paper presents a very realistic objective of the firm, which is consistent with organizational behavior. It is being proposed that: The firm sets as its objective, the control of the optimum amount of financial capital at the minimum cost to the firm. As evidenced by the large portfolios of marketable equity securities held by non-financial firms, the firm hoards financial capital in order to ensure future availability. There is a holding or storage cost; that is, in pursuing this objective, the firm incurs (pays) a premium to ensure control over an attained level of financial capital. This study maintains that this cost is tantamount to a premium as in the case of an insurance policy. Thus, corporate earnings retention is a case of optimization under uncertainty and dividend policy is viewed as an instrument of risk management. This objective, which addresses the underinvestment problem, fills the gap on what the firm should maximize and provides an alternative to the debatable "maximization of shareholders' wealth."

© 2007 IUP . All Rights Reserved.

Stochastic Breakeven Yields for Investment Risk Analysis

-- Bharat M Upadhyay and Douglas L Young

A new concept, `stochastic breakeven yields', is used to illustrate the risk levels associated with short run and long run transitions to new technology. The breakeven yield implies the same probability of dynamic business failure for both, the old and new technologies. The framework has an intuitive appeal because while prices are beyond the farmer's control, a farmer often has some perceptions of the likely yield performance. An application to the transition to no-till farming showed that breakeven yield premiums to make no-till farming was equally risky as conventional tillage farming, varied with farm size, proportion of rented land, and transition strategies. The choice of minimizing yield premium was consistent across planning horizons. Immediate adoption of no-till was found to be preferable for large farms when the transition involved buying a no-till drill. For smaller farms, the preferred transition strategy was to rent a drill and gradually expand the no-till area.

© 2007 IUP . All Rights Reserved.

Prudential Standards and the Performance of Urban Cooperative Banks in India: An Empirical Investigation

--K Ramesha and G Nagaraju

The Urban Cooperative Bank (UCB) segment, which was considered as one of the robust and fast expanding segments of the banking system till the late 1990s, has become one of the weakest with regular cases of failures. This paper clearly establishes the relationship between the extension/tightening of prudential standards and performance of UCB. On one hand, the share of deposits and advances of UCB to the total of the banking system has shown a declining trend, while on the other hand, the tightening of prudential standards particularly, after 2000-01 has resulted in a significant structural break in the direction of growth rates of key variables. This trend, if continued for next 4-5 years would not only further reduce the contribution of UCB, but also may result in failures on a much larger scale. It must be recognized that the UCB is driven by the philosophy of cooperation and in an increasingly competitive environment, an urban bank becomes more vulnerable to factors like size, location and compulsions to lend to a sector and thus, is deprived of scale economies. Rather than tackling the ever-increasing number of weak and sick UCBs through restructuring and rehabilitation programs, the Government/RBI must revisit the idea of setting up of a separate regulatory body for UCBs and promote professionalism and governance, so that the impact of size related disadvantages of UCBs can be minimized to some extent. For smaller UCBs, a different set of norms may be carved out from the existing prudential standards and for larger UCBs having multi state presence and offering full range of banking services, perhaps appropriate regulatory and supervisory mechanism is a prerequisite for the extension of prudential standards on par with other players.

© 2007 IUP . All Rights Reserved.

The Equity Risk Premium in January 2007: Evidence from the Global CFO Outlook Survey

-- John R Graham and Campbell R Harvey

In this paper, the authors analyze the results of the most recent survey of US Chief Financial Officers (CFOs), which looks ahead to the first quarter of 2007 and beyond. They present the expectations of the equity risk premium measured over a ten-year horizon relative to a ten-year US Treasury bond. This multi-year survey has been conducted every quarter from June 2000 to November 2006. Each quarterly survey provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk Premium assessment. The authors also present evidence on the determinants of the long run risk premium. The analysis suggests that there is a positive correlation between the ex ante risk premium and real interest rates as reflected in the Treasury Inflation Indexed Notes. The level of risk premium also appears to track market volatility as reflected in the VIX index.

© 2007 IUP . All Rights Reserved.

Interest Rates: The Behavior, Term Structure and Risk Structure

-- Fadil Govori

From the financial markets point of view the interest rate can be considered as the price of money. This makes the interest rate a very important instrument for efficient financial markets performance and a vital tool of the government's economic management. The control of interest rates is passed over to the Central Bank. There are many different interest rates. Interest rates will vary according to the amount of time money is tied up for and the riskiness of the investment. The actual interest rate depends on a number of factors. These include: The length of time for which the money is borrowed (or saved); the security of the loan (or investment); the nature of the financial institution the money is borrowed from (or lent to); the amount of competition between financial institutions. Changes in interest rates affect different aspects of the economy (growth, prices, employment, spending, etc.). That is the interest rate transmission mechanism: One of the peculiarities of the money market is its way of quoting interest rates. Some money market instruments (treasury bills, commercial paper, and bankers' acceptances) are quoted on a discount basis. Other rates (fed funds, federal reserve discount rate, and repo rates) are quoted on an add-on basis. Each of these rates is different from the yield to maturity, the rate generally used for comparing coupon-bearing bonds. There are at least five different money market rates: the discount rate, the add-on rate, the bond equivalent yield, and the semi-annual and annual yields to maturity. Both nominal and real interest rates differ by maturity or term. A schedule of spot interest rates by maturity is called the term structure of interest rates. The term structure can be rising, flat, declining or humped. Bonds and other debt instruments have varying degrees of default risk, and the yields on these instruments reflect the market's assessment of this default risk. The relationship among these interest rates is called the risk structure of interest rates.

© 2007 IUP . All Rights Reserved.