The Oxford Guide to Financial Modeling Applications for Capital Markets, Corporate Finance, Risk Management and Financial Institutions

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ISBN: 9780195169621 | 019516962X
Cover: Hardcover
Copyright: 1/15/2004

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The Oxford Guide to Financial Modeling is accompanied by a companion web site that serves as an interactive workbook designed specifically for the book. This site is simple to use yet exceedingly robust with regard to its technological efficiency and purposeful usability. It is designed to further enhance understanding of the use and applications of the models referred to in the book and it is accessible free of charge at www.thomasho.com. This on-line workbook and resource tool contains more than 95 downloadable Excel models. The models provide clear expositions of the mathematical formulations and can be used along with the book. The companion web site is rich with a plethora of research and analytic tools designed for "doing finance" on-line.

Model List

xxiii

PART I. DERIVATIVES VALUATION

1. Introduction: Discounted Cash Flow Method

(13)

1.1 Examples of Financial Issues

(3)

1.2 Financial Models

(3)

1.3 Basics of Modeling: Present Value and Measures of Risk

(5)

1.4 Summary

(2)

2. Equity Market: The Capital Asset Pricing Model

(27)

2.1 Real and Financial Sectors

(1)

2.2 Stocks and Stock Markets

(4)

2.3 Perfect Capital Market

(2)

2.4 Efficient Capital Market Hypothesis

(1)

2.5 Diversification

(4)

2.6 Capital Asset Pricing Model (CAPM)

(2)

2.7 Beta-The Systematic Risk

(2)

2.8 The Stock Model-Dividend Discount Model

(2)

2.9 An Application of the Capital Asset Pricing Model in Investment Services

(1)

2.10 Empirical Tests of the Capital Asset Pricing Model

(2)

2.11 Summary

(1)

Appendix A. Expectations and Standard Deviations

(1)

Appendix B. A Summary of the CAPM

(5)

3. Bond Markets: The Bond Model

(37)

3.1 Bond Mathematics

(2)

3.2 Bonds and Bond Markets

(2)

3.3 Swap Markets

(1)

3.4 Economics of the Yield Curve

(4)

3.5 The Bond Model

(3)

3.6 Forward Prices and Forward Rates

(6)

3.7 Bond Analysis

(8)

3.8 Applications of the Bond Analytics

(3)

3.9 Law of One Price: An Arbitrage Trade and Fair Value Analysis

(1)

3.10 Summary

(1)

Appendix A. Taylor Expansion

(1)

Appendix B. The Derivation of Macaulay Duration and Convexity

(1)

Appendix C. Duration and Convexity in Measuring Price Sensitivity

(3)

4. Equity Options: the Black-Scholes Model

(43)

4.1 Description of an Option

(2)

4.2 Institutional Framework

(1)

4.3 Put-Call Parity

(2)

4.4 The Main Insight of the Black-Scholes Model

(7)

4.5 Valuation Methods

(4)

4.6 Relationships of Risk-Neutral and Market Binomial Lattices

(2)

4.7 Option Behavior and the Sensitivity Analysis

(2)

4.8 Extensions of the Black-Scholes Model

100

(2)

4.9 Option Pricing Procedure and Analytic Framework

102

(1)

4.10 Applications of Option Models

103

(3)

4.11 Accounting for Employee Stock Options

106

(1)

4.12 Intuitive Explanations of the Behavior of an Equity Option

107

(1)

4.13 Summary

108

(1)

Appendix A. Derivation of the Black-Scholes Continuous Time Model Using Different Numeraires

109

(4)

Appendix B. The Relationship Between the Time Decay and the Gamma of a Delta-Neutral Portfolio

113

(1)

Appendix C. Pathwise Valuation

114

(1)

Appendix D. Derivation of Discrete Time Parameters

115

(1)

Appendix E. Monte Carlo Simulation and Finite Difference Method

116

(7)

5. Interest Rate Derivatives: Interest Rate Models

123

(49)

5.1 Interest Rate Movements: Historical Experiences

124

(5)

5.2 The Three-Factor Yield Curve Movement Model

129

(3)

5.3 Equilibrium Models

132

(4)

5.4 Arbitrage-Free Models

136

(20)

5.5 A Comparison of Models

156

(1)

5.6 Generalizations of Interest Rate Models

157

(6)

5.7 Summary

163

(1)

Appendix A. Yield Curve Movements Represented by the Principal Components

164

(1)

Appendix B. Derivation of Ho Lee, Extended Ho Lee, and Ho Lee Two-Factor Models

164

(8)

6. Implied Volatility Surface: Calibrating the Models

172

(42)

6.1 Implied Volatility Surface and Benchmark Securities

173

(2)

6.2 Price Quotes of Benchmark Securities

175

(7)

6.3 Valuation of Interest Rate Derivatives Using Market Benchmark Prices

182

(3)

6.4 Calibration of the Black Derman-Toy Model

185

(1)

6.5 Calibration of the Ho-Lee Models

186

(2)

6.6 Calibration of the Longstaff-Santa-Clara-Schwartz "String" Model

188

(5)

6.7 Calibration of the Brace-Gatarek Musiela/Jamshidian Model (the LIBOR Market Model)

193

(2)

6.8 Comparing the Black Models and the Interest Rate Models

195

(5)

6.9 Applications of Interest Rate Models

200

(3)

6.10 Key Rate Duration and Dynamic Hedging

203

(4)

6.11 Pathwise Valuation and Decomposition of an Option

207

(2)

6.12 Intuitive Explanation of the Bond Option Valuation

209

(1)

6.13 Lecture on Convexity

210

(1)

6.14 Summary

211

(3)

7. Exotic Options: Bellman's Optimization, the Filtration Model, and the n-Factor Model

214

(45)

7.1 Options with Alternative Payoffs at Expiration

215

(1)

7.2 Options with Boundary Conditions

216

(2)

7.3 Options with the Early Exercise Feature (American) and the Bellman Optimization

218

(5)

7.4 Compound Options

223

(2)

7.5 Options with Look-back Features (Asian) and the Filtration Model

225

(7)

7.6 Choosey Option

232

(1)

7.7 Multiple Risk Sources

233

(5)

7.8 Constant Maturity Swap

238

(2)

7.9 Interest Rate Spread Option

240

(2)

7.10 Options on Forward/Futures Contracts

242

(1)

7.11 Commodity Options

243

(4)

7.12 An Overview of the Valuation Framework

247

(1)

7.13 Summary

248

(1)

Appendix A. Optimal Early Exercise Using Simulations

249

(1)

Appendix B. N-Factor Lattice Model

249

(3)

Appendix C. A Numerical Example of Dynamic Programming

252

(7)

PART II. CORPORATE LIABILITIES

8. Investment Grade Corporate Bonds: Option Adjusted Spreads

259

(39)

8.1 Describing a Corporate Bond

260

(5)

8.2 Valuation of a Bond

265

(9)

8.3 Numerical Examples

274

(6)

8.4 Liquidity (Marketability) Spread

280

(3)

8.5 Credit Scoring Approaches

283

(1)

8.6 Bond Analysis

284

(2)

8.7 Numerical Example: Valuing a Eurobond Issue

286

(2)

8.8 Applications of Bond Analytics

288

(2)

8.9 Explaining the Concept of the Arbitrage-free Condition on a Solemn Occasion

290

(1)

8.10 Summary

290

(2)

Appendix. Callable Bond and Sinking Fund Bond Pricing

292

(6)

9. High Yield Corporate Bonds: The Structural Models

298

(34)

9.1 An Example of a High-Yield Bond

299

(4)

9.2 Institutional Framework of Bankruptcy and Bankruptcy Proceedings

303

(3)

9.3 The Fisher Model

306

(1)

9.4 An Actuarial Model

306

(2)

9.5 Historical Experience and Estimation of the Parameters of Default Models

308

(4)

9.6 The Reduced Form Models

312

(1)

9.7 The Structural Model

313

(4)

9.8 Valuation of a Debt Package Using a Compound Option Model

317

(4)

9.9 Empirical Evidence

321

(1)

9.10 A Review of the High Yield Bond Models

322

(1)

9.11 Analysis of the McLeod USA Bond

323

(1)

9.12 Analysis of Credit Risk

324

(3)

9.13 Summary

327

(5)

10. Convertibles, MBS/CMO, and Other Bonds: The Behavioral Models

332

(34)

10.1 Convertible Bonds

333

(8)

10.2 Mortgage-Backed Securities (Pass-through Certificates)

341

(8)

10.3 Collateralized Mortgage Obligations (CMO)

349

(3)

10.4 Other Bonds

352

(4)

10.5 Credit Derivatives

356

(2)

10.6 Managing a CMO Portfolio

358

(5)

10.7 Summary

363

(3)

11. Financial Institutions' Liabilities: Required Option Adjusted Spread

366

(47)

11.1 Balance Sheet Analysis-Book Value

367

(1)

11.2 Fair Values

368

(6)

11.3 Liability Modeling

374

(2)

11.4 Bank Liabilities

376

(4)

11.5 Property and Casualty Insurance

380

(5)

11.6 Life Insurance Products

385

(19)

11.7 Pension Liabilities

404

(2)

11.8 Applications of the Financial Models to Liability Management

406

(1)

11.9 'Not If, But When"

407

(1)

11.10 Summary

408

(5)

PART III. CORPORATE FINANCE

12. Valuation of a Firm: The Business Model

413

(39)

12.1 Descriptions of a Firm

414

(3)

12.2 Traditional Firm Valuation Methodologies

417

(2)

12.3 Corporate Financial Decisions and Firm Value Maximization

419

(2)

12.4 Miller-Modigliani Theories

421

(7)

12.5 Free Cash Flow Discount Model

428

(2)

12.6 Business Model

430

(10)

12.7 Implications of the Valuation Model

440

(1)

12.8 Analyses of the Business Model

441

(1)

12.9 From the Senior Management Perspective

442

(1)

12.10 Summary

443

(1)

Appendix A. The MM Propositions

444

(2)

Appendix B. The Miller Model

446

(6)

13. Strategic Value of a Firm: Real Options

452

(41)

13.1 Characteristics of a Growth Company An Example of Real Options

453

(1)

13.2 Salient Features of Real Options

454

(3)

13.3 Examples of Real Options in Capital Budgeting

457

(4)

13.4 Examples of Businesses with Embedded Options

461

(2)

13.5 Strategic Value of a Firm

463

(2)

13.6 Analysis of the Real Option Value

465

(2)

13.7 A Business Model with Embedded Options: Starbucks Coffee Japan

467

(3)

13.8 A Business Model Approach and the Free Cash Flow Discounting Approach-A Comparison

470

(1)

13.9 Empirical Implications of the Business Model

471

(4)

13.10 Implications of the Business Model

475

(4)

13.11 Empirical Research on Real Options

479

(1)

13.12 What is Financial Modeling to Senior Management?

479

(1)

13.13 Summary

480

(1)

Appendix. The Business Model

481

(12)

14. Optimal Corporate Financial Decisions: Corporate Model

493

(32)

14.1 Corporate Financial Planning-the DFA Approach

494

(3)

14.2 Extensions of the MM Theory

497

(3)

14.3 Empirical Evidence on the MM Theory and Its Extensions

500

(4)

14.4 The Corporate Model

504

(2)

14.5 Specifications of the Corporate Model

506

(6)

14.6 A Comparison with Previous Research

512

(1)

14.7 New Perspectives in Viewing Firms as Contingent Claims

513

(3)

14.8 Principles of Risk Management

516

(1)

14.9 Summary

517

(1)

Appendix. The Firm Model

518

(7)

15. Risk Management

525

(40)

15.1 Risk Measurement-Value at Risk

526

(2)

15.2 Market Risk

528

(1)

15.3 Delta Normal Methodology

529

(6)

15.4 Historical Simulation Methodology

535

(2)

15.5 Monte Carlo Simulation Methodology

537

(1)

15.6 Extreme Value Theory

538

(2)

15.7 Credit Risk

540

(6)

15.8 Risk Reporting

546

(2)

15.9 Risk Monitoring

548

(1)

15.10 Risk Management

549

(4)

15.11 Boardroom with a View-The Coffin story

553

(1)

15.12 Summary

554

(1)

Appendix A. Selected Historical Financial Losses

554

(5)

Appendix B. Lessons Learned from the Historical Financial Losses

559

(6)

16. Financial Institutions: Applications of Financial Models

565

(41)

16.1 An Overview of the Financial Sector

566

(3)

16.2 Organization and the Business Model of a Financial Institution

569

(3)

16.3 Financial Disclosures on Valuation

572

(3)

16.4 Risk Management

575

(1)

16.5 Capital Allocation and Risk Adjusted Performance Measures

576

(2)

16.6 Financial Modeling of a Financial Institution

578

(14)

16.7 Applications: Asset and Liability Management

592

(2)

16.8 Regulatory Issues

594

(5)

16.9 Summary

599

(1)

Appendix A. What Actions Have Commercial Banks Taken?

600

(2)

Appendix B. Capital Requirements and Risk-based Capital

602

(4)

17. Structured Finance: Foreign Exchange Models

606

(14)

17.1 Background

606

(1)

17.2 Economics of the Structure

607

(1)

17.3 Deal Structure

608

(3)

17.4 Pricing

611

(3)

17.5 Simulations

614

(1)

17.6 VaR Calculation

615

(1)

17.7 Remarks

616

(1)

17.8 Concluding Remarks on Financial Modeling

617

(1)

Appendix A. Total Return Swap Terms and Conditions as of January 29, 1997

618

(1)

Appendix B. Indonesian Rupiah-Linked Notes Final Terms and Conditions

618

(1)

Appendix C. The Put-Call Parity

619

(1)

18. Concluding Thoughts

620

(13)

18.1 Conceptual Development of Financial Models

621

(1)

18.2 Overview of Valuation Models

622

(2)

18.3 Applications of the Financial Models

624

(3)

18.4 Financial Modeling as a Process

627

(1)

18.5 Looking into the Future

628

(3)

18.6 The World of Contingent Claims

631

(2)

19. Technical Matters: Market Model and Binomial Lattices

633

(48)

19.1 Building a Market Model in a Binomial Lattice

634

(13)

19.2 A General Approach to Valuation

647

(13)

19.3 Comparison of the Option Derivation Between Discrete Time and Continuous Time

660

(9)

Appendix A. Continuous Time Versions of the Ho Lee Models

669

(5)

Appendix B. Summary of Continuous Time Interest Rate Models

674

(3)

Appendix C. Recombining Lattice

677

(4)

Glossary of Notations

681

(6)

Glossary of Terms

687

(18)

Index

705

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The Oxford Guide to Financial Modeling Applications for Capital Markets, Corporate Finance, Risk Management and Financial Institutions

Summary

Author Biography

Table of Contents

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