Financial Terms related to Model This document is part of the valuable contents available at www.ftpall.com, a free online glossary with more than five thousand financial and business terms. This document can be copied and distributed freely Find thousands of financial terms at www.ftpall.com respecting its original format. It is forbidden its transcription, translation or change on its format without authorization of its author or editor. MODEL Arbitrage free option pricing models • Yield curve option-pricing models. Asset pricing model • A model, such as the Capital Asset Pricing Model (CAPM), that determines the required rate of return on a particular asset. Bankruptcy prediction models • 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). www.ftpall.com 2|Page Binomial option pricing model • 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. Black option model • Is the Black-Scholes option model modified by Fischer Black for the futures markets. Find thousands of financial terms at www.ftpall.com Black scholes option model • 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. Black scholes option pricing model • 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. Business model eps projection • 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 www.ftpall.com 3|Page 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. Capital asset pricing model Find thousands of financial terms at www.ftpall.com • Abbreviated CAPM. The basic theory that links together risk and return for all assets. The CAPM predicts a relationship between the required return, or cost of common equity capital, and the nondiversifiable risk of the firm as measured by the beta coefficient. • Abbreviated CAPM. An economic theory that describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification. The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a risk premium. • 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. Constant growth dividend valuation gordon model • Assumes that the value of a share of stock equals the present value of all future www.ftpall.com 4|Page dividends (assumed to grow at a constant rate) that it is expected to provide over an infinite time horizon. The model assumes that dividends will grow at a rate that is less than the required rate of return. Constant growth model • Also called the Gordon-Shapiro model, an application of the dividend discount model which assumes (1) a fixed growth rate for future dividends and (2) a single discount rate. • A widely cited dividend valuation approach that assumes that dividends will grow at Find thousands of financial terms at www.ftpall.com a constant rate that is less than the required return. Country risk analysis models • 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. Credit scoring models • 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 Discounted dividend model • Abbreviated DDM. A formula to estimate the intrinsic value of a firm by figuring the present value of all expected future dividends. www.ftpall.com 5|Page Dividend discount model • Abbreviated DDM. A model for valuing the common stock of a company, based on the present value of the expected cash flows. Dividend growth model • A model wherein dividends are assumed to be at a constant rate in perpetuity. Dividend valuation model • Abbreviated DVM. The value of common shares is dependent upon the sum of the Find thousands of financial terms at www.ftpall.com present value of the dividends received over an infinite time horizon. Extrapolative statistical models • 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. Garmen kohlhagen option pricing model • A widely used model for pricing foreign currency options. Gordon model • A common name for the constant growth model that is widely cited in dividend valuation. Ho lee option model • Is an Arbitrage Free Model which uses an estimated spot curve to evaluate embedded options in credit or fixed income securities. Index model www.ftpall.com 6|Page • 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 Find thousands of financial terms at www.ftpall.com returns on the market portfolio. Miller orr model • A model that provides for cost-efficient transactional cash balances; assumes uncertain cash flows and determines an upper limit and return point for cash balances. Modeling • The process of creating a depiction of reality, such as a graph, picture, or mathematical representation. Option adjusted spread model • Is an approach whereby securities are evaluated by considering the implied option characteristics. Two key variables are interest rate and prepayment rate behavior. These models incorporate the average spread of the Mortgage Backed Security or CMO tranche to the treasury yield curve. The usual reason for differences in evaluations is due to assumptions and modeling efforts for prepayments. 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 www.ftpall.com 7|Page 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, Find thousands of financial terms at www.ftpall.com the modifications are at the practices level in order to expedite calculations. Pie model of capital structure • 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. Simple linear trend model • An extrapolative statistical model that asserts that earnings have a base level and grow at a constant amount each period. Single factor model • A model of security returns that acknowledges only one common factor. See: factor model. Single index model • Related: market model • A model of stock returns that decomposes influences on returns into a systematic factor, as measured by the return on the broad market index, and firm specific factors. Stochastic models • Liability-matching models that assume that the liability payments and the asset www.ftpall.com 8|Page cash flows are uncertain. Related: Deterministic models. Two factor model • Black's zero-beta version of the capital asset pricing model. Two state option pricing model • 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. Find thousands of financial terms at www.ftpall.com Value at risk model • Abbreviated VAR. Procedure for estimating the probability of portfolio losses exceeding some specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities. Variable growth model • A dividend valuation approach that allows for a change in the dividend growth rate. Yield curve option pricing models • 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. Zero growth model • An approach to dividend valuation that assumes a constant, nongrowing dividend stream.