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Encyclopedia of Financial Models II

Book Description

An essential reference dedicated to a wide array of financial models, issues in financial modeling, and mathematical and statistical tools for financial modeling

The need for serious coverage of financial modeling has never been greater, especially with the size, diversity, and efficiency of modern capital markets. With this in mind, the Encyclopedia of Financial Models, 3 Volume Set has been created to help a broad spectrum of individuals—ranging from finance professionals to academics and students—understand financial modeling and make use of the various models currently available.

Incorporating timely research and in-depth analysis, the Encyclopedia of Financial Models is an informative 3-Volume Set that covers both established and cutting-edge models and discusses their real-world applications. Edited by Frank Fabozzi, this set includes contributions from global financial experts as well as academics with extensive consulting experience in this field. Organized alphabetically by category, this reliable resource consists of three separate volumes and 127 entries—touching on everything from asset pricing and bond valuation models to trading cost models and volatility—and provides readers with a balanced understanding of today's dynamic world of financial modeling.

  • This 3-Volume Set contains coverage of the fundamentals and advances in financial modeling and provides the mathematical and statistical techniques needed to develop and test financial models

  • Emphasizes both technical and implementation issues, providing researchers, educators, students, and practitioners with the necessary background to deal with issues related to financial modeling

  • Each volume includes a complete table of contents and index for easy access to various parts of the encyclopedia

Financial models have become increasingly commonplace, as well as complex. They are essential in a wide range of financial endeavors, and this 3-Volume Set will help put them in perspective.

Table of Contents

  1. Cover
  2. Title Page
  3. Copyright
  4. About the Editor
  5. Contributors
  6. Preface
    1. TOPIC CATEGORIES
  7. Guide to the Encyclopedia of Financial Models
    1. ORGANIZATION
  8. Equity Models and Valuation
    1. Dividend Discount Models
      1. DIVIDEND MEASURES
      2. DIVIDENDS AND STOCK PRICES
      3. BASIC DIVIDEND DISCOUNT MODELS
      4. THE FINITE LIFE GENERAL DIVIDEND DISCOUNT MODEL
      5. CONSTANT GROWTH DIVIDEND DISCOUNT MODEL
      6. MULTIPHASE DIVIDEND DISCOUNT MODELS
      7. STOCHASTIC DIVIDEND DISCOUNT MODELS
      8. EXPECTED RETURNS AND DIVIDEND DISCOUNT MODELS
      9. KEY POINTS
      10. REFERENCES
    2. Discounted Cash Flow Methods for Equity Valuation
      1. DIVIDEND DISCOUNT MODEL
      2. CONSTANT-GROWTH DDM
      3. NONCONSTANT-GROWTH DDM
      4. INTUITION BEHIND THE DDM
      5. COMPLICATIONS IN IMPLEMENTING THE DDM IN THE REAL WORLD
      6. ADAPTING TO THE COMPLICATIONS: THE EARNINGS PER SHARE APPROACH
      7. FREE CASH FLOW DCF MODEL—TOTAL FIRM VALUATION
      8. CALCULATING FCF
      9. USING THE CASH-FLOW STATEMENT TO ARRIVE AT OCF AND FCF
      10. VALUING THE TOTAL FIRM
      11. ESTIMATING TOTAL FIRM VALUE USING THE FCF MODEL
      12. KEY POINTS
      13. REFERENCES
    3. Relative Valuation Methods for Equity Analysis
      1. BASIC PRINCIPLES OF RELATIVE VALUATION
      2. HYPOTHETICAL EXAMPLE
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
    4. Equity Analysis in a Complex Market
      1. AN INTEGRATED APPROACH TO A SEGMENTED MARKET
      2. DISENTANGLING
      3. CONSTRUCTING, TRADING, AND EVALUATING PORTFOLIOS
      4. PROFITING FROM COMPLEXITY
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
    5. Equity Portfolio Selection Models in Practice
      1. PORTFOLIO CONSTRAINTS COMMONLY USED IN PRACTICE
      2. BENCHMARK EXPOSURE AND TRACKING ERROR MINIMIZATION
      3. INCORPORATING TRANSACTION COSTS
      4. INCORPORATING TAXES
      5. MULTIACCOUNT OPTIMIZATION
      6. ROBUST PARAMETER ESTIMATION
      7. PORTFOLIO RESAMPLING
      8. ROBUST PORTFOLIO OPTIMIZATION
      9. KEY POINTS
      10. NOTES
      11. REFERENCES
    6. Basics of Quantitative Equity Investing
      1. EQUITY INVESTING
      2. FUNDAMENTAL VS. QUANTITATIVE INVESTOR
      3. THE QUANTITATIVE STOCK SELECTION MODEL
      4. THE OVERALL QUANTITATIVE INVESTMENT PROCESS
      5. RESEARCH
      6. PORTFOLIO CONSTRUCTION
      7. MONITORING
      8. CURRENT TRENDS
      9. KEY POINTS
      10. NOTES
    7. Quantitative Equity Portfolio Management
      1. TRADITIONAL AND QUANTITATIVE APPROACHES TO EQUITY PORTFOLIO MANAGEMENT
      2. FORECASTING STOCK RETURNS, RISKS, AND TRANSACTION COSTS
      3. CONSTRUCTING PORTFOLIOS
      4. TRADING
      5. EVALUATING RESULTS AND UPDATING THE PROCESS
      6. KEY POINTS
      7. REFERENCES
    8. Forecasting Stock Returns
      1. THE CONCEPT OF PREDICTABILITY
      2. A CLOSER LOOK AT PRICING MODELS
      3. PREDICTIVE RETURN MODELS
      4. IS FORECASTING MARKETS WORTH THE EFFORT?
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
  9. Factor Models for Portfolio Construction
    1. Factor Models
      1. ARBITRAGE PRICING THEORY
      2. TYPES OF FACTOR MODELS
      3. FACTOR MODEL ESTIMATION
      4. USE OF PRINCIPAL COMPONENTS ANALYSIS
      5. KEY POINTS
      6. REFERENCES
    2. Principal Components Analysis and Factor Analysis
      1. FACTOR MODELS
      2. PRINCIPAL COMPONENTS ANALYSIS
      3. FACTOR ANALYSIS
      4. PCA AND FACTOR ANALYSIS COMPARED
      5. KEY POINTS
      6. REFERENCES
    3. Multifactor Equity Risk Models and Their Applications
      1. MOTIVATION
      2. EQUITY RISK FACTOR MODELS
      3. APPLICATIONS OF EQUITY RISK MODELS
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    4. Factor-Based Equity Portfolio Construction and Analysis
      1. FACTOR-BASED TRADING
      2. DEVELOPING FACTOR-BASED TRADING STRATEGIES
      3. RISK TO TRADING STRATEGIES
      4. DESIRABLE PROPERTIES OF FACTORS
      5. SOURCES FOR FACTORS
      6. BUILDING FACTORS FROM COMPANY CHARACTERISTICS
      7. WORKING WITH DATA
      8. ANALYSIS OF FACTOR DATA
      9. KEY POINTS
      10. NOTES
      11. REFERENCES
    5. Cross-Sectional Factor-Based Models and Trading Strategies
      1. CROSS-SECTIONAL METHODS FOR EVALUATION OF FACTOR PREMIUMS
      2. FACTOR MODELS
      3. PERFORMANCE EVALUATION OF FACTORS
      4. MODEL CONSTRUCTION METHODOLOGIES FOR A FACTOR-BASED TRADING STRATEGY
      5. BACKTESTING
      6. BACKTESTING OUR FACTOR TRADING STRATEGY
      7. KEY POINTS
      8. APPENDIX: THE COMPUSTAT POINT-IN-TIME, IBES CONSENSUS DATABASES AND FACTOR DEFINITIONS
      9. NOTES
      10. REFERENCES
    6. The Fundamentals of Fundamental Factor Models
      1. FUNDAMENTAL ANALYSIS AND THE BARRA FUNDAMENTAL FACTOR MODEL
      2. CRITICAL INSIGHTS FROM THE BARRA FUNDAMENTAL FACTOR MODEL
      3. RISK DECOMPOSITION
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    7. Multifactor Equity Risk Models and Their Applications
      1. MODEL DESCRIPTION AND ESTIMATION
      2. RISK DECOMPOSITION
      3. APPLICATIONS IN PORTFOLIO CONSTRUCTION AND RISK CONTROL
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    8. Multifactor Fixed Income Risk Models and Their Applications
      1. APPROACHES USED TO ANALYZE RISK
      2. APPLICATIONS OF RISK MODELING
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
  10. Financial Econometrics
    1. Scope and Methods of Financial Econometrics
      1. THE DATA GENERATING PROCESS
      2. FINANCIAL ECONOMETRICS AT WORK
      3. TIME HORIZON OF MODELS
      4. APPLICATIONS
      5. KEY POINTS
      6. REFERENCES
    2. Regression Analysis: Theory and Estimation
      1. THE CONCEPT OF DEPENDENCE
      2. REGRESSIONS AND LINEAR MODELS
      3. ESTIMATION OF LINEAR REGRESSIONS
      4. SAMPLING DISTRIBUTIONS OF REGRESSIONS
      5. DETERMINING THE EXPLANATORY POWER OF A REGRESSION
      6. USING REGRESSION ANALYSIS IN FINANCE
      7. NONNORMALITY AND AUTOCORRELATION OF THE RESIDUALS
      8. PITFALLS OF REGRESSIONS
      9. KEY POINTS
      10. NOTES
      11. REFERENCES
    3. Categorical and Dummy Variables in Regression Models
      1. INDEPENDENT CATEGORICAL VARIABLES
      2. DEPENDENT CATEGORICAL VARIABLES
      3. KEY POINTS
      4. NOTE
      5. REFERENCES
    4. Quantile Regression
      1. COMPARING QUANTILE AND OLS APPROACHES
      2. REASONS FOR USING QUANTILE METHODS
      3. BACKGROUND AND FURTHER EXAMPLES
      4. KEY POINTS
      5. REFERENCES
    5. ARCH/GARCH Models in Applied Financial Econometrics
      1. REVIEW OF LINEAR REGRESSION AND AUTOREGRESSIVE MODELS
      2. ARCH/GARCH MODELS
      3. WHY ARCH/GARCH?
      4. GENERALIZATIONS OF THE ARCH/GARCH MODELS
      5. KEY POINTS
      6. REFERENCES
    6. Classification and Regression Trees and Their Use in Financial Modeling
      1. TECHNICAL DETAILS
      2. TREE PRUNING
      3. STRENGTHS AND WEAKNESSES OF CART
      4. APPLICATION OF CART IN STOCK SELECTION
      5. KEY POINTS
      6. NOTE
      7. ACKNOWLEDGMENT
      8. REFERENCES
    7. Applying Cointegration to Problems in Finance
      1. STATIONARY AND NONSTATIONARY VARIABLES AND COINTEGRATION
      2. TESTING FOR COINTEGRATION
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
    8. Nonlinearity and Nonlinear Econometric Models in Finance
      1. STUDY OF NONLINEARITY IN ECONOMETRICS AND STATISTICS
      2. NONLINEAR MODELS
      3. NONLINEARITY TESTS
      4. 1 MODELING
      5. FORECASTING
      6. 2 APPLICATION
      7. KEY POINTS
      8. REFERENCES
    9. Robust Estimates of Betas and Correlations
      1. OLS REVISITED
      2. THEIL-SEN REGRESSION
      3. ROBUST ESTIMATES OF BETA
      4. ROBUST ESTIMATES OF CORRELATION
      5. KEY POINTS
      6. REFERENCES
    10. Working with High-Frequency Data
      1. WHAT ARE HIGH-FREQUENCY DATA?
      2. HOW ARE HIGH-FREQUENCY DATA RECORDED?
      3. PROPERTIES OF HIGH-FREQUENCY DATA
      4. HIGH-FREQUENCY DATA ARE VOLUMINOUS
      5. HIGH-FREQUENCY DATA ARE SUBJECT TO BID-ASK BOUNCE
      6. HIGH-FREQUENCY DATA ARE IRREGULARLY SPACED IN TIME
      7. KEY POINTS
      8. REFERENCES
  11. Financial Modeling Principles
    1. Milestones in Financial Modeling
      1. THE PRECURSORS: PARETO, WALRAS, AND THE LAUSANNE SCHOOL
      2. PRICE DIFFUSION: BACHELIER
      3. THE RUIN PROBLEM IN INSURANCE: LUNDBERG
      4. THE PRINCIPLES OF INVESTMENT: MARKOWITZ
      5. UNDERSTANDING VALUE: MODIGLIANI AND MILLER
      6. EFFICIENT MARKETS: FAMA AND SAMUELSON
      7. CAPITAL ASSET PRICING MODEL: SHARPE, LINTNER, AND MOSSIN
      8. THE MULTIFACTOR CAPM: MERTON
      9. ARBITRAGE PRICING THEORY: ROSS
      10. ARBITRAGE, HEDGING, AND OPTION THEORY: BLACK, SCHOLES, AND MERTON
      11. KEY POINTS
      12. REFERENCES
    2. From Art to Financial Modeling
      1. THE ROLE OF INFORMATION TECHNOLOGY
      2. INTEGRATING QUALITATIVE AND QUANTITATIVE INFORMATION
      3. PRINCIPLES FOR ENGINEERING A SUITE OF MODELS
      4. KEY POINTS
      5. REFERENCES
    3. Basic Data Description for Financial Modeling and Analysis
      1. DATA TYPES
      2. FREQUENCY DISTRIBUTIONS
      3. EMPIRICAL CUMULATIVE FREQUENCY DISTRIBUTION
      4. DATA CLASSES
      5. CUMULATIVE FREQUENCY DISTRIBUTIONS
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
    4. Time Series Concepts, Representations, and Models
      1. CONCEPTS OF TIME SERIES
      2. STYLIZED FACTS OF FINANCIAL TIME SERIES
      3. INFINITE MOVING-AVERAGE AND AUTOREGRESSIVE REPRESENTATION OF TIME SERIES
      4. ARMA REPRESENTATIONS
      5. INTEGRATED SERIES AND TRENDS
      6. APPENDIX
      7. KEY POINTS
      8. NOTE
      9. REFERENCES
    5. Extracting Risk-Neutral Density Information from Options Market Prices
      1. AN APPROPRIATE PARAMETRIC MODEL
      2. TWO PARAMETRIC MODELS FOR RND ESTIMATION
      3. FITTING THE MODELS TO DATA
      4. KEY POINTS
      5. NOTE
      6. REFERENCES
  12. Financial Statement Analysis
    1. Financial Statements
      1. ACCOUNTING PRINCIPLES
      2. INFORMATION CONVEYED BY THE BASIC FINANCIAL STATEMENTS
      3. ACCOUNTING FLEXIBILITY
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    2. Financial Ratio Analysis
      1. RATIOS AND THEIR CLASSIFICATION
      2. RETURN-ON-INVESTMENT RATIOS
      3. LIQUIDITY
      4. PROFITABILITY RATIOS
      5. ACTIVITY RATIOS
      6. FINANCIAL LEVERAGE RATIOS
      7. COMMON-SIZE ANALYSIS
      8. USING FINANCIAL RATIO ANALYSIS
      9. KEY POINTS
      10. REFERENCES
    3. Cash-Flow Analysis
      1. DIFFICULTIES WITH MEASURING CASH FLOW
      2. CASH FLOWS AND THE STATEMENT OF CASH FLOWS
      3. FREE CASH FLOW
      4. CALCULATING FREE CASH FLOW
      5. NET FREE CASH FLOW
      6. USEFULNESS OF CASH FLOWS IN FINANCIAL ANALYSIS
      7. KEY POINTS
      8. REFERENCES
  13. Finite Mathematics for Financial Modeling
    1. Important Functions and Their Features
      1. CONTINUOUS FUNCTION
      2. INDICATOR FUNCTION
      3. DERIVATIVES
      4. MONOTONIC FUNCTION
      5. INTEGRAL
      6. SOME FUNCTIONS
      7. KEY POINTS
      8. REFERENCES
    2. Time Value of Money
      1. IMPORTANCE OF THE TIME VALUE OF MONEY
      2. DETERMINING THE FUTURE VALUE
      3. DETERMINING THE PRESENT VALUE
      4. DETERMINING THE UNKNOWN INTEREST RATE
      5. DETERMINING THE NUMBER OF COMPOUNDING PERIODS
      6. THE TIME VALUE OF A SERIES OF CASH FLOWS
      7. VALUING CASH FLOWS WITH DIFFERENT TIME PATTERNS
      8. LOAN AMORTIZATION
      9. THE CALCULATION OF INTEREST RATES AND YIELDS
      10. KEY POINTS
      11. NOTE
      12. REFERENCES
    3. Fundamentals of Matrix Algebra
      1. VECTORS AND MATRICES DEFINED
      2. SQUARE MATRICES
      3. DETERMINANTS
      4. SYSTEMS OF LINEAR EQUATIONS
      5. LINEAR INDEPENDENCE AND RANK
      6. VECTOR AND MATRIX OPERATIONS
      7. MATRIX OPERATIONS
      8. EIGENVALUES AND EIGENVECTORS
      9. KEY POINTS
      10. NOTES
    4. Difference Equations
      1. THE LAG OPERATOR L
      2. HOMOGENEOUS DIFFERENCE EQUATIONS
      3. NONHOMOGENEOUS DIFFERENCE EQUATIONS
      4. SYSTEMS OF LINEAR DIFFERENCE EQUATIONS
      5. SYSTEMS OF HOMOGENEOUS LINEAR DIFFERENCE EQUATIONS
      6. KEY POINTS
      7. NOTE
      8. REFERENCES
    5. Differential Equations
      1. DIFFERENTIAL EQUATIONS DEFINED
      2. ORDINARY DIFFERENTIAL EQUATIONS
      3. SYSTEMS OF ORDINARY DIFFERENTIAL EQUATIONS
      4. CLOSED-FORM SOLUTIONS OF ORDINARY DIFFERENTIAL EQUATIONS
      5. NUMERICAL SOLUTIONS OF ORDINARY DIFFERENTIAL EQUATIONS
      6. NONLINEAR DYNAMICS AND CHAOS
      7. KEY POINTS
      8. NOTES
      9. REFERENCES
    6. Partial Differential Equations in Finance
      1. PARTIAL DIFFERENTIAL EQUATIONS FOR OPTION PRICING
      2. PRICING EUROPEAN OPTIONS WITH PDES
      3. PRICING AMERICAN OPTIONS WITH PDES
      4. CALIBRATION
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
  14. Model Risk and Selection
    1. Model Risk
      1. MODELS AND MODEL RISK
      2. SOURCES OF MODEL RISK
      3. MANAGING MODEL RISK
      4. KEY POINTS
      5. REFERENCES
    2. Model Selection and Its Pitfalls
      1. MODEL SELECTION AND ESTIMATION
      2. THE (MACHINE) LEARNING APPROACH TO MODEL SELECTION
      3. SAMPLE SIZE AND MODEL COMPLEXITY
      4. DANGEROUS PATTERNS OF BEHAVIOR
      5. DATA SNOOPING
      6. SURVIVORSHIP BIASES AND OTHER SAMPLE DEFECTS
      7. MOVING TRAINING WINDOWS
      8. MODEL RISK
      9. MODEL SELECTION IN A NUTSHELL
      10. KEY POINTS
      11. REFERENCES
    3. Managing the Model Risk with the Methods of the Probabilistic Decision Theory
      1. AN OUTLINE OF PROBABLISTIC DECISION THEORY
      2. MODEL RISK OF A SIMPLE PORTFOLIO
      3. INVESTMENT IN A RISKY BOND
      4. KEY POINTS
      5. REFERENCES
    4. Fat-Tailed Models for Risk Estimation
      1. THE FUNDAMENTALS: NORMAL DISTRIBUTION
      2. INCORPORATING HEAVY TAILS AND SKEWNESS: PARAMETRIC FAT-TAILED MODELS
      3. INCORPORATING HEAVY TAILS AND SKEWNESS: SEMI-PARAMETRIC FAT-TAILED MODELS
      4. COMPARISON AMONG RISK MODELS
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
  15. Index