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MODEL
Arbitrage free option pricing models
• A model, such as the Capital Asset Pricing Model (CAPM), that determines the
required rate of return on a particular asset.
• Bankruptcy Prediction Models refer to the quantitative models that estimate the
probability of bankruptcy for a given firm or a bank.
Baumol model
• A model that provides for cost-efficient transactional cash balances; assumes that
the demand for cash can be predicted with certainty and determines the economic
conversion quantity (ECQ).
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• An option pricing model in which the underlying asset can take on only two
possible, discrete values in the next time period for each value that it can take on in
the preceding time period.
• Is the Black-Scholes option model modified by Fischer Black for the futures
markets.
• Is the seminal work about options pricing models. It was developed by Fisher Black
and Myron Scholes. It initially focused on securities prices. Subsequently, it was
refined by Fisher Black for the futures markets. Most options models depart from this
seed. This important work was published by Fischer Black and Myron Scholes in the
May-June 1973 edition of The Journal of Political Economy. It laid the foundation for
the quantitative analysis and practical calculation of puts and calls. The model
indicated that options would eliminate risk from stock portfolios subject to some
assumptions. The lognormal model stated that option values could be determined by
using the current stock price, time left to expiration, the strike or exercise price, the
variance of the stock's rate of return (standard deviation applied) and the risk-free
rate of interest.
• A model for pricing call options based on arbitrage arguments that uses the stock
price, the exercise price, the risk-free interest rate, the time to expiration, and the
standard deviation of the stock return.
• Estimates EPS by applying profit and tax margins to the projected sales rate five
years into the future. This centers attention on profitability rather than sales
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expansion. This formula may be used to estimate earnings per share five years
ahead. It starts with the sales growth projection. (This is used because sales growth
is historically more consistent and stable than earnings growth.) Expenses, taxes,
and preferred dividends are then subtracted from sales. Finally, the result is divided
by the shares outstanding to show the 5-year forecast for EPS. It is worthwhile to
compare this sales-based EPS projection with other methods. This should help to
confirm the reasonableness of your future 5-year EPS projection.
• Is a tool that relates an asset's expected return to the market's expected return. It
combines the concepts of efficient capital markets with risk premiums. The idea of
capital market efficiency assumes immediate instantaneous -response to perfect or
near perfect information. The risk premiums relate an investment to the market's
risk-free or riskless rate of return. Typically, this risk-free rate is viewed in terms of
principal safety for short term U.S. government obligations. Here, beta relates the
volatility of an asset to the market.
• Assumes that the value of a share of stock equals the present value of all future
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• A widely cited dividend valuation approach that assumes that dividends will grow at
• Country Risk Analysis Models incorporate variables such as Debt Service ratio,
Import Ratio, Variance of Export Revenue. Domestic Money Supply Growth Rate
and others to predict the probability of debt rescheduling problems.
• These are quantitative models that predict bankruptcy. They establish which
factors are important with regard to credit risk. They evaluate the relative importance
of these risk factors, improve the estimation of default probability, automate the
rejection of bad loan applicants, and improve the pricing of the loan. They also help
calculate any potential future loan losses and possible revenues.
Deterministic models
• Liability-matching models that assume that the liability payments and the asset
cash flows are known with certainty. Related: Compare stochastic models
• Abbreviated DDM. A formula to estimate the intrinsic value of a firm by figuring the
present value of all expected future dividends.
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• Abbreviated DDM. A model for valuing the common stock of a company, based on
the present value of the expected cash flows.
• Abbreviated DVM. The value of common shares is dependent upon the sum of the
• Models that apply a formula to historical data and project results for a future period.
Such models include the simple linear trend model, the simple exponential model,
and the simple autoregressive model.
Factor model
• A way of decomposing the factors that influence a security's rate of return into
common and firm-specific influences.
Gordon model
• A common name for the constant growth model that is widely cited in dividend
valuation.
Index model
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• A model of stock returns using a market index such as the S&P 500 to represent
common or systematic risk factors.
Market model
• This relationship is sometimes called the single-index model. The market model
says that the return on a security depends on the return on the market portfolio and
the extent of the security's responsiveness as measured, by beta. In addition, the
return will also depend on conditions that are unique to the firm. Graphically, the
market model can be depicted as a line fitted to a plot of asset returns against
Modeling
Option models
• Are evaluation tools to determine the price, the premium, or the volatility for a put,
call, or complex position or strategy. Sometimes, the list for option models includes:
convertible securities, mortgage and asset backed securities, and warrants. Option
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models may be categorized as credit, currency, equity, index, futures, and physical
or cash oriented. The basic factors for an option model are: the underlying market
price, the strike or exercise price, the interest rate for discounting purposes, the
volatility, and the time to expiration. Some models require expected dividends,
coupons and foreign exchange considerations. Some of these models are: Binomial,
Black, Black Scholes, Cox, Ingersoll, and Ross (CIR), Gastineau-Madansky, Heath,
Jarrow, and Morton (HJM), Ho and Lee, Hull and White, Jamshidian, Rendleman
and Bartter, Vasicek, and Whaley. Often these models have modifications. Usually,
• A model of the debt/equity ratio of the firms, graphically depicted in slices of a pie
that represent the value of the firm in the capital markets.
• An extrapolative statistical model that asserts that earnings have a base level and
grow at a constant amount each period.
• A model of security returns that acknowledges only one common factor. See: factor
model.
Stochastic models
• Liability-matching models that assume that the liability payments and the asset
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• An option pricing model in which the underlying asset can take on only two
possible (discrete) values in the next time period for each value it can take on in the
preceding time period. Also called the binomial option pricing model.
• A dividend valuation approach that allows for a change in the dividend growth rate.
• Models that can incorporate different volatility assumptions along the yield curve,
such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing
models.