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

by Ho, Thomas S. Y.; Lee, Sang Bin

• ISBN13: 9780195169621
• ISBN10: 019516962X
• Format: Hardcover
• Copyright: 2004-01-15
• Publisher: Oxford University Press

Summary

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.

Author Biography

Thomas S.Y. Ho,is president of Thomas Ho Company. Previously he was Executive Vice President of BARRA, Inc. He founded GAT, a financial software company that had over 200 institutional clients globally. He served as a professor in finance at New York University's Stern School of Business. He is an associate editor of the Journal of Investment Management, International Journal of Theoretical and Applied Finance, and Journal of Derivatives. He received his Ph.D. in Mathematics from the University of Pennsylvania. Sang Bin Lee, is a professor of finance at the School of Busines Administration, Hangyang University in Seoul, Korea and President of the Korean Securities Association. Previously, he was an assistant director Ministry of Finance, Korea and an Independent Director and a member of Risk Management Committee, Hana Bank. Currently, he serves as a member of Primary Dealers Screening Committee, Ministry of Finance, Korea and a member of Unfair Trading Examination Committee, Financial Supervisory Service, Korea. Professor Lee received his Ph.D. in Finance from New York University's Stern School of Business. Dr. Ho and Professor Lee have published extensively in major journals. They are the authors of the Ho-Lee Model, the first and widely cited arbitrage-free interest rate model.

Table of Contents

Model List	xxiii
PART I. DERIVATIVES VALUATION
1. Introduction: Discounted Cash Flow Method	3	(13)
1.1 Examples of Financial Issues	3	(3)
1.2 Financial Models	6	(3)
1.3 Basics of Modeling: Present Value and Measures of Risk	9	(5)
1.4 Summary	14	(2)
2. Equity Market: The Capital Asset Pricing Model	16	(27)
2.1 Real and Financial Sectors	17	(1)
2.2 Stocks and Stock Markets	18	(4)
2.3 Perfect Capital Market	22	(2)
2.4 Efficient Capital Market Hypothesis	24	(1)
2.5 Diversification	25	(4)
2.6 Capital Asset Pricing Model (CAPM)	29	(2)
2.7 Beta-The Systematic Risk	31	(2)
2.8 The Stock Model-Dividend Discount Model	33	(2)
2.9 An Application of the Capital Asset Pricing Model in Investment Services	35	(1)
2.10 Empirical Tests of the Capital Asset Pricing Model	35	(2)
2.11 Summary	37	(1)
Appendix A. Expectations and Standard Deviations	37	(1)
Appendix B. A Summary of the CAPM	38	(5)
3. Bond Markets: The Bond Model	43	(37)
3.1 Bond Mathematics	44	(2)
3.2 Bonds and Bond Markets	46	(2)
3.3 Swap Markets	48	(1)
3.4 Economics of the Yield Curve	49	(4)
3.5 The Bond Model	53	(3)
3.6 Forward Prices and Forward Rates	56	(6)
3.7 Bond Analysis	62	(8)
3.8 Applications of the Bond Analytics	70	(3)
3.9 Law of One Price: An Arbitrage Trade and Fair Value Analysis	73	(1)
3.10 Summary	74	(1)
Appendix A. Taylor Expansion	75	(1)
Appendix B. The Derivation of Macaulay Duration and Convexity	76	(1)
Appendix C. Duration and Convexity in Measuring Price Sensitivity	77	(3)
4. Equity Options: the Black-Scholes Model	80	(43)
4.1 Description of an Option	80	(2)
4.2 Institutional Framework	82	(1)
4.3 Put-Call Parity	83	(2)
4.4 The Main Insight of the Black-Scholes Model	85	(7)
4.5 Valuation Methods	92	(4)
4.6 Relationships of Risk-Neutral and Market Binomial Lattices	96	(2)
4.7 Option Behavior and the Sensitivity Analysis	98	(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