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From the Editor 

Entering its fourth year of publication, Financial Services Review has tenaciously held to its 

editorial policy of publishing only high-quality research in the field of individual financial 
management. The dual criteria of academic rigor and focus on the individual have had the 

disadvantage, from an editor’s perspective, of limiting the number of manuscripts submitted 

for publication. However, the scope and caliber of articles that have been published in the 
first seven issues of this journal have set the foundation for an academically respectable 

subspecialization of finance. 
The five articles in the current issue continue to apply the tools of modern financial 

analysis to decisions faced by individuals and their advisors. Some decisions are complex, 

such as the use of junior equity interests to save taxes when passing on a family business to 

the next generation. Others appear to be mundane, such as the purchase of U.S. savings 

bonds, the true value of which can only be evaluated through option pricing analysis. 

Many individuals own stock in banks. This is due to the fact that banks make up a 

sizeable proportion of publically traded corporations in the United States as well as to the 

local or regional appeal stemming from prohibitions on nationwide banking. To a great 

extent, the financial condition of banks depends upon the fair market value of their assets 

and liabilities, figures which need be reported only as a footnote to the annual financial 
statement. Lacking this information on an ongoing basis, investors must seek other clues 

about the banks’ financial condition. In their article titled “Bank Dividend Policy as a Signal 
of Bank Quality,” Boldin and Leggett examine the extent to which the dividend policy of 

bank holding companies is a signal of their quality. The argument is that banking organiza- 

tions in poor financial condition are unlikely to distribute large cash dividends. The study 

found a positive relationship between bank dividends per share and bank quality rating but 

also found an inverse relationship between the dividend payout ratio and bank quality. Banks 

that paid out a large proportion of earnings in the form of dividends were left with little in 

the way of retained earnings to build up a capital position. 

Hamill and Steinberg examine a complex but important issue in their article titled “Tax 

Savings Opportunities in Estate Freeze Transactions: An Application of the Black Scholes 
Model.” Since much of the growth in employment in the United States comes from smaller, 

often family-owned businesses, there is policy interest in smoothing the ownership succes- 
sion of these businesses from one generation to the next. However, with federal estate taxes 

taking as much as half the value of assets passed to descendents, it is difficult to keep a 
business in the family. 

One method of doing so involves the use of two classes of stock. The older family 
members will recapitalize the company, retaining voting preferred equity for themselves and 

passing on the common equity to the next-generation managers, This transaction has the 

effect of freezing the value of the corporation at the time of recapitalization for estate tax 

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vu1 FINANCIAL SERVICES REVIEW, 4( 1) 1995 

purposes and passing on an option to the younger generation to acquire the preferred shares 
at this frozen price after the death of their elders. If the corporation has grown in value, this 
call option may become quite valuable. 

In a series of tax law changes in 1987 and 1990, Congress tried to deal with the value 
of these options for estate tax purposes, first assigning a minimum value of 20% of the 
interests held by the senior generation family members and then lowering that to just 10%. 
The article shows how the Black-Scholes option pricing model can be used to value the 
junior interest created by the freeze and to determine whether a freeze, with the statutory 
minimum value set by Congress, is justified. This article may be of great value for valuation 
experts brought in advise the family on whether they should recapitalize. 

The third article, “Quantifying Present Valuation Errors” by Mangier0 and Mangiero, 
will be of interest to anyone who has learned or taught finance using the ubiquitous present 
value tables. While we have intuitively realized that linear interpolation was inaccurate, this 
article shows mathematically why it is inaccurate and estimates the degree of error. Although 

the use of computers and finance calculators have rendered these tables obsolete, the authors 
point out that many existing mortgage contracts and other installment contracts that are 
several years old may be inaccurate as well, resulting perhaps in overcharges which may be 

recoverable. 
The fourth article, “A Simplified Approach to Measuring Bond Duration” by Heck, 

Zivney, and Modani, gives readers a quick way to approximate duration and convexity. This 
will make it less daunting for those who wish to have a quick estimate of interest rate risk 
when evaluating alternative investments. 

In their article titled “Analysis of U.S. Savings Bonds,” Potts and Reichenstein find that 
these bonds are complex contracts which have some valuable features that are often 

overlooked. For example, as opposed to other bonds of comparable duration and coupon, 
the value of savings bonds (which can be redeemed at any time) cannot go below the purchase 
price plus some stated (positive) rate of interest. This put option, which is generally 

overlooked by financial planners, can make a savings bond a better buy at times than other 
bonds that lack this feature. 

As begun in the previous issue, managing editor Barbara Poole gives readers her 

perspective on how an article from this issue can be used in practice. Finally, Phyllis Schiller 
Myers presents abstracts of articles relating to individual financial management from a 
variety of academic journals. 

Lewis Mandell 
Editor