RichardMichelfelder devised a new theoretical financial model adapted from morerestrictive versions that fail to provide consistent and credible results.

CAMDEN — A
formula that more accurately predicts the rate of return on stocks and bonds
has been developed by two Rutgers–Camden finance professors, whose research
innovation is already making waves in the public utilities industry.

Richard
Michelfelder and Eugene Pilotte, both scholars at the Rutgers School of
Business–Camden, devised a new theoretical financial model adapted from more
restrictive versions that fail to provide consistent and credible results.

“We typically
use previous data to make a prediction about what’s going to happen to the
stock price or rate of return on an investment,” says Michelfelder, a clinical
associate professor of finance. “But you can’t convert historic data into
forward-looking data.”

Developed at
Rutgers–Camden, this new model instead predicts the volatility, or variation,
of stocks and bonds in the market to come to conclusions about rate of return.
The researchers say the ebbs and flows of the stock market are easy to pinpoint
because they’re frequent.

“In a typical
year, you see different high and low volatility periods,” Michelfelder
explains. “The stock market and bond market are in one state or the other. The
stock market swings every day, but it has a tendency to cluster. Sometimes, you
don’t want to look at the stock market because it’s boring. Then, before you
know it, it starts to rock and roll again.”

Michelfelder
says one could predict high volatility or low volatility in the market for all
but about 10 days during the course of a year, when the market turns and heads
in the other direction.

“We can
predict volatility for the next day, next month, next quarter, or even the next
business cycle,” he says. “You just can’t predict exactly when it will change.
A vast majority of the time, we predict it correctly. So if we take predicted
volatility and plug it into our model, it gives us predicted rate of return.”

The article
Michelfelder and Pilotte wrote to introduce their theory, “Treasury Bond risk
and return, the implications for the hedging of consumption and lessons for
asset pricing,” was published in the Journal
of Economics and Business in late 2011.

The theory
started to attract the attention of the public utilities sector when
Michelfelder’s article “New approach to estimating the cost of common equity
capital for public utilities” appeared in the Journal of Regulatory Economics at the same time.

“We took the
model and applied it to come up with a fair rate of return on public utility
stocks,” says Michelfelder, who has 30 years of experience as a public
utilities consultant. “It’s gaining traction because other models are old. The
industry was clamoring for something different. It’s been tested and it makes
sense. It doesn’t give consistently high numbers, which is what the utilities
want, and it doesn’t give low numbers, which is what the state wants. It’s not
biased to one party or another.”

Michelfelder
says his formula has already been widely accepted by the American Gas Association,
the Edison Electrical Institute, trade associations, and other public utility
regulators.

“Our model
makes very few assumptions,” he continues. “The fundamentals of volatility
haven’t changed. You are getting a true prediction of rate of return and not a
historical mean.”

-30-