SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH
ROBERT A. EISENBEIS
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research
GERALD P. DWYER JR.
Vice President, Financial
ELLIS W. TALLMAN
Vice President, Macropolicy
JOHN C. ROBERTSON
Assistant Vice President, Regional
BOBBIE H. MCCRACKIN
LYNN H. FOLEY
CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Marketing and Circulation
The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
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|Direct Investments in Securities: A Primer
|Ramon P. DeGennaro
|Direct investment plans (commonly known as DRIPs) let investors bypass traditional investment channels and avoid problems such as high transactions costs and the relatively large dollar amounts necessary to purchase certain assets. While no one expects these plans to answer all of the modern investor’s needs, DRIPs probably appeal to the buy-and-hold clientele seeking the lowest possible transactions costs.
This article discusses DRIPs, describing how the financial services industry has evolved to meet the needs of the small investor. The author identifies the remaining limitations on this sort of investment, noting that mutual funds continue to offer convenience and unmatched diversification for small accounts. He then presents reasons why companies might offer DRIPs. For example, companies that face political or regulatory scrutiny may want a broad, stable ownership base. Such shareholders also tend to vote with management, offering potential as a takeover defense. Finally, a broad ownership base provides opportunities for cross-selling.
The article also identifies empirical differences between companies that offer DRIPs and those that do not. The analysis shows that large companies, more mature companies, and companies in industries that are subject to relatively high levels of regulation are more likely to offer the plans.
Finally, the discussion speculates about the future of direct investments. One obvious tool for DRIP investors is the Internet. Broker-run DRIPs provide another evolutionary direction.
|Pension Systems and Aggregate Shocks
|The U.S. Social Security Trust Fund faces depletion over the coming decades, and there is a near consensus that social security reform is necessary. Under one suggestion for partial privatization, current surpluses would fund private, individual retirement accounts, and the private savings would make up for future benefit cuts.
Moving away from social security, however, causes some people to point toward excessive risks associated with private savings. But social security cannot be completely riskless either because its long-term viability depends on such volatile factors as productivity growth, fertility, and immigration, which make social security risky for the same reasons financial assets are.
To quantify the sensitivity of different retirement schemes to large aggregate shocks, this article provides a model economy in which aggregate shocks affect not only financial market returns but also a pay-as-you-go (PAYGO) pension system. The model depicts a life-cycle economy in which agents work when they are young and their old-age consumption is financed by a combination of a PAYGO pension system and private savings.
The model simulations show that, in the long run, privatization makes every generation better off, even if a large aggregate shock occurs. The intuition for this result is that under a privatized pension system, savings are higher. This higher savings level increases the capital stock and thus increases welfare enough to insulate all future generations even from large shocks.
|How Much Do We Really Know about Growth and Finance?
|During the past twenty-five years, development economists have made a major shift toward a more mainstream, market-oriented approach to the financial sector. Economists now take for granted that a well-developed financial sector contributes to economic growth. But until recently there was surprisingly little solid evidence to support this view.
This article assesses the econometric evidence about the finance-growth relationship. The author first describes the regression framework that has become the standard for assessing this relationship. He outlines some methodological reservations about the evidence used to establish this consensus, pointing out the drawbacks of using aggregate measures of activity.
Over the last decade, a large body of empirical work using this framework has provided results that relate different dimensions of financial sector development to economic growth. The observed relationships in these studies appear convincingly to be causal, from finance to growth, and not the result of simultaneity or reverse causality. However, the author points out, the literature has not yet adequately explained what happens when the financial sector deepens or how that deepening affects behavior and economic growth.
Research so far provides policymakers little guidance about how best to develop the financial sector or about the optimal sequence of developments. But the next generation of research has already begun to delve into the “black box.” The author discusses a few of these studies that attempt to show how financial deepening effects are transmitted into the real sector.
|Pricing Firms on the Basis of Fundamentals
|Determining the right or fair price of a stock is one of the oldest problems in finance. Business mergers and acquisitions rely on this information, but only in the last several decades have formal models been developed to address the question. This article focuses on fundamental valuation, a technique that determines the right price by forecasting cash flows from a stock market investment and calculating what that income is worth.
The author first provides an overview of the literature and an illustration of commonly used fundamental valuation techniques based on relative valuation and the Gordon growth model and then discusses a valuation approach he developed in 2001. His work incorporates the proceeds from share liquidation into the cash flows that are used to value the firm, accounting for the reduction in future growth of cash flows from this liquidation of shares. The author demonstrates these methods by applying them to pricing BellSouth shares, the S&P 500 index, and some new-economy stocks. The discussion also looks at prices and estimated fundamental values during severe market turndowns.
Pricing BellSouth using sales and sales growth is consistent with its dramatic rise and recent decline in price, the author finds; this method is also appropriate for a small group of high-growth stocks. Fundamental models, however, have more trouble explaining the price movements of the overall market. The author concludes that algorithmic valuation techniques provide, at best, a rough starting point for firm valuation.