A NEW APPROACH TO CONTROLLING FOR THIN TRADING

Recent research has shown that thin trading can seriously bias beta estimates. Present techniques for controlling this bias in research designs involve the adjustment of OLS betas. This paper presents a new methodology that controls for this bias by forming portfolios where the level of thin trading is held constant, while the difference of another variable, pertinent to a specific research design, is maximized across the portfolios. Directly controlling the level of thin trading avoids reliance on beta adjustment techniques. Further, the linear programming model permits the control of the mean and higher moments of additional variables across portfolios.     

A NEW APPROACH TO CAPITAL BUDGETING FOR FINANCIAL INSTITUTIONS

The classic approach to capital budgeting based on the standard Capital Asset Pricing Model (CAPM) says that the hurdle rate (or cost of capital) for any new project or investment should depend only on the riskiness of that investment. Thus, the hurdle rate, and hence the expected value of the investment, should not be affected by the financial policy of the company evaluating the project. Nor should the hurdle rate be influenced by the company's risk management policy, or by the kind of assets it already has on the balance sheet. This article argues that such a “singlefactor” model may be inappropriate for banks and other financial institutions for two main reasons:

• ? it is especially costly for banks to raise new external funds on short notice;
• ? it is costly for banks to hold a buffer stock of equity capital on the balance sheet, even if this equity is accumulated over time through retained earnings.

The single-factor CAPM ignores such costs and, in so doing, understates the true economic costs of “illiquid” bank investments. Illiquid investments require special treatment because they impose risks that, although “diversifiable” by shareholders, cannot be readily hedged by the bank and therefore require it to hold more equity capital. The authors accordingly propose a “two-factor” model for capital budgeting— one in which banks' investment decisions are linked to their capital structure and risk management decisions. One of the key implications of the two-factor model is that a bank should evaluate new investments according to both their correlation with the market portfolio and their correlation with the bank's existing portfolio of unhedgeable risks. The authors describe several potential applications of their model, including the evaluation of proprietary trading operations and the pricing of unhedgeable derivatives positions. They also compare their approach to the RAROC methodology that has been adopted by a number of banks.     

MEASURING CORPORATE TAX RATES AND TAX INCENTIVES: A NEW APPROACH

Taxes play an important but underemphasized role in the valuation of a company and its projects. For example, the authors estimate that the expected tax benefits from interest deductions by all publicly traded U.S. corporations were responsible for almost $1.4 trillion of their total market value of $12.7 trillion in 1991. In the case of RJR's 1989 leveraged buyout alone, the capitalized value of the interest tax shield amounted to several billion dollars (or about 25%) of the company's market value.
This article argues that, to maximize shareholder wealth, the corporate planning process should include a careful analysis of corporate tax incentives. Using several examples, the authors show how earnings variability and major provisions of the tax code interact to affect a company's expected marginal tax rate. After describing the complexities involved in properly calculating corporate tax rates, the article concludes by describing a simulation method the authors have developed to measure a company's effective marginal tax rate and, hence, its tax incentives to use more leverage (or some other means of reducing taxable income).
In furnishing a method for calculating marginal tax rates with greater accuracy, the authors also provide a clue to resolving the capital structure puzzle discussed in the roundtable at the head of this issue. In particular, their recent research corrects earlier studies in the finance literature by showing that when marginal tax rates are measured before financing (that is, based on income before interest expense is deducted), there is a positive relation between debt usage and tax rates.     

MEASURING THE MEANING OF FINANCIAL STATEMENT TERMINOLOGY: A PSYCHOLINGUISTICS APPROACH

Measuring the meaning of communication between and among producers (certified public accountants, academic accountants, and private accountants) and users (chartered financial analysts, commercial bank loan officers, and shareholders) of financial statements is the purpose of this study. Two psycholinguistic techniques, classification analysis and association analysis, were used in a field experiment to measure the intergroup and intragroup transference of denotative (objective) and connotative (subjective) meaning, respectively. The study concluded that we are somewhere in between the “worst” and the “best” on a communication continuum. The evidence indicated only one communication problem — a problem involving the transfer of connotative (subjective) meaning on an intergroup basis, that is, between producers and users.     

A SIMPLIFIED APPROACH TO SHORT-TERM INTERNATIONAL DIVERSIFICATION

Using Eurocurrency deposit interest rates, currency exchange rates, and inflation rates in a mean-variance portfolio analysis, the authors develop portfolios of interest-bearing deposits in London banks denominated in various currencies. These easily constructed multicurrency portfolios are shown to provide better risk-return positions than comparable single currency holdings.