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Encyclopedia of Financial Models I

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. Asset Allocation
    1. Mean-Variance Model for Portfolio Selection
      1. SOME BASIC CONCEPTS
      2. MEASURING A PORTFOLIO’S EXPECTED RETURN
      3. MEASURING PORTFOLIO RISK
      4. PORTFOLIO DIVERSIFICATION
      5. CHOOSING A PORTFOLIO OF RISKY ASSETS
      6. ROBUST PORTFOLIO OPTIMIZATION
      7. KEY POINTS
      8. NOTES
      9. REFERENCES
    2. Principles of Optimization for Portfolio Selection
      1. UNCONSTRAINED OPTIMIZATION
      2. CONSTRAINED OPTIMIZATION
      3. KEY POINTS
      4. REFERENCES
    3. Asset Allocation and Portfolio Construction Techniques in Designing the Performance-Seeking Portfolio
      1. THE TANGENCY PORTFOLIO AS THE RATIONALE BEHIND SHARPE RATIO MAXIMIZATION
      2. ROBUST ESTIMATORS FOR COVARIANCE PARAMETERS
      3. ROBUST ESTIMATORS FOR EXPECTED RETURNS
      4. IMPLICATIONS FOR BENCHMARK PORTFOLIO CONSTRUCTION
      5. ASSET ALLOCATION MODELING: PUTTING THE EFFICIENT BUILDING BLOCKS TOGETHER
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
  9. Asset Pricing Models
    1. General Principles of Asset Pricing
      1. ONE-PERIOD FINITE STATE ECONOMY
      2. PORTFOLIOS AND MARKET COMPLETENESS
      3. THE LAW OF ONE PRICE AND LINEAR PRICING
      4. ARBITRAGE AND POSITIVE STATE PRICING
      5. THE FUNDAMENTAL THEOREM OF ASSET PRICING
      6. DISCOUNT FACTOR MODELS
      7. STOCHASTIC DISCOUNT FACTORS
      8. KEY POINTS
      9. REFERENCES
    2. Capital Asset Pricing Models
      1. INTRODUCTION
      2. SHARPE-LINTNER CAPM
      3. ROY CAPM
      4. CONFUSIONS REGARDING THE CAPM
      5. TWO MEANINGS OF MARKET EFFICIENCY
      6. CAPM INVESTORS DO NOT GET PAID FOR BEARING RISK
      7. THE “TWO BETA” TRAP
      8. KEY POINTS
      9. NOTES
      10. REFERENCES
    3. Modeling Asset Price Dynamics
      1. FINANCIAL TIME SERIES
      2. BINOMIAL TREES
      3. ARITHMETIC RANDOM WALKS
      4. GEOMETRIC RANDOM WALKS
      5. MEAN REVERSION
      6. ADVANCED RANDOM WALK MODELS
      7. STOCHASTIC PROCESSES
      8. KEY POINTS
      9. REFERENCES
    4. Arbitrage Pricing: Finite-State Models
      1. THE ARBITRAGE PRINCIPLE
      2. ARBITRAGE PRICING IN A ONE-PERIOD SETTING
      3. ARBITRAGE PRICING IN A MULTIPERIOD FINITE-STATE SETTING
      4. THE BINOMIAL MODEL
      5. ARBITRAGE PRICING IN A DISCRETE-TIME, CONTINUOUS-STATE SETTING
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
    5. Arbitrage Pricing: Continuous-State, Continuous-Time Models
      1. THE ARBITRAGE PRINCIPLE IN CONTINUOUS TIME
      2. ARBITRAGE PRICING IN CONTINUOUS-STATE, CONTINUOUS-TIME
      3. OPTION PRICING
      4. STATE-PRICE DEFLATORS
      5. EQUIVALENT MARTINGALE MEASURES
      6. EQUIVALENT MARTINGALE MEASURES AND GIRSANOV'S THEOREM
      7. EQUIVALENT MARTINGALE MEASURES AND COMPLETE MARKETS
      8. EQUIVALENT MARTINGALE MEASURES AND STATE PRICES
      9. ARBITRAGE PRICING WITH A PAYOFF RATE
      10. IMPLICATIONS OF THE ABSENCE OF ARBITRAGE
      11. WORKING WITH EQUIVALENT MARTINGALE MEASURES
      12. KEY POINTS
      13. NOTES
      14. REFERENCES
  10. Bayesian Analysis and Financial Modeling Applications
    1. Basic Principles of Bayesian Analysis
      1. THE LIKELIHOOD FUNCTION
      2. BAYES’ THEOREM
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
    2. Introduction to Bayesian Inference
      1. PRIOR INFORMATION
      2. POSTERIOR INFERENCE
      3. BAYESIAN PREDICTIVE INFERENCE
      4. ILLUSTRATION: POSTERIOR TRADE-OFF AND THE NORMAL MEAN PARAMETER
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
    3. Bayesian Linear Regression Model
      1. THE UNIVARIATE LINEAR REGRESSION MODEL
      2. THE MULTIVARIATE LINEAR REGRESSION MODEL
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
    4. Bayesian Estimation of ARCH-Type Volatility Models
      1. BAYESIAN ESTIMATION OF THE GARCH(1,1) MODEL
      2. MARKOV-SWITCHING GARCH MODELS
      3. APPENDIX: THE GRIDDY GIBBS SAMPLER
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    5. Bayesian Techniques and the Black-Litterman Model
      1. PRACTICAL PROBLEMS ENCOUNTERED IN MEAN-VARIANCE OPTIMIZATION
      2. SHRINKAGE ESTIMATION
      3. THE BLACK-LITTERMAN MODEL
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
  11. Bond Valuation
    1. Basics of Bond Valuation
      1. GENERAL PRINCIPLES OF BOND VALUATION
      2. ARBITRAGE-FREE BOND VALUATION
      3. KEY POINTS
      4. NOTES
      5. REFERENCES
    2. Relative Value Analysis of Fixed-Income Products
      1. YIELD SPREADS OVER SWAP AND TREASURY CURVES
      2. ASSET SWAPS
      3. CREDIT DEFAULT SWAPS
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    3. Yield Curves and Valuation Lattices
      1. THE INTEREST RATE LATTICE
      2. CALIBRATING THE LATTICE
      3. USING THE LATTICE FOR VALUATION
      4. KEY POINTS
      5. NOTE
      6. REFERENCES
    4. Using the Lattice Model to Value Bonds with Embedded Options, Floaters, Options, and Caps/Floors
      1. FIXED-COUPON BONDS WITH EMBEDDED OPTIONS
      2. FLOATING-COUPON BONDS WITH EMBEDDED OPTIONS
      3. VALUING CAPS AND FLOORS
      4. VALUATION OF TWO MORE EXOTIC STRUCTURES
      5. VALUING AN OPTION ON A BOND
      6. EXTENSIONS
      7. KEY POINTS
      8. NOTES
      9. REFERENCES
    5. Understanding the Building Blocks for OAS Models
      1. IS IT EQUILIBRIUM OR AN ARBITRAGE MODEL?
      2. WHICH IS THE RIGHT MODEL OF THE INTEREST RATE PROCESS?
      3. TERM STRUCTURE MODELS: WHICH IS THE RIGHT APPROACH FOR OAS?
      4. IS THERE A RIGHT WAY TO MODEL PREPAYMENTS?
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
    6. Quantitative Models to Value Convertible Bonds
      1. ANALYTICAL MODELS
      2. NUMERICAL MODELS
      3. KEY POINTS
      4. REFERENCES
    7. Quantitative Approaches to Inflation-Indexed Bonds
      1. BOND STRUCTURES AND THE CONCEPT OF REAL YIELD
      2. INFLATION-INDEXED BONDS IN A NOMINAL PORTFOLIO
      3. ADVANCED ANALYTICAL APPROACHES TO INFLATION-INDEXED BONDS
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
  12. Credit Risk Modeling
    1. An Introduction to Credit Risk Models
      1. KEY OBJECTIVES IN CREDIT RISK MODELING
      2. RATINGS AND “CREDIT SCORES” VERSUS DEFAULT PROBABILITIES
      3. WHAT “THROUGH THE CYCLE” REALLY MEANS
      4. VALUATION, PRICING, AND HEDGING
      5. EMPIRICAL DATA ON CREDIT SPREADS AND COMMON STOCK PRICES
      6. STRUCTURAL MODELS OF RISKY DEBT
      7. REDUCED-FORM MODELS OF RISKY DEBT
      8. EMPIRICAL EVIDENCE ON MODEL PERFORMANCE
      9. KEY POINTS
      10. NOTES
      11. REFERENCES
    2. Default Correlation in Intensity Models for Credit Risk Modeling
      1. PRELIMINARIES
      2. SINGLE ENTITY
      3. DEFAULT CORRELATION
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    3. Structural Models in Credit Risk Modeling
      1. REVIEW OF STRUCTURAL MODELS
      2. SINGLE FIRM
      3. DEFAULT CORRELATION
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    4. Modeling Portfolio Credit Risk
      1. ELEMENTS OF CREDIT RISK
      2. KEY POINTS
      3. REFERENCES
    5. Simulating the Credit Loss Distribution
      1. MONTE CARLO METHODS
      2. KEY POINTS
      3. REFERENCES
    6. Managing Credit Spread Risk Using Duration Times Spread (DTS)
      1. THE DTS CONCEPT
      2. DTS AS BETA-ADJUSTED SPREAD DURATION
      3. THE RELATION BETWEEN SPREAD VOLATILITY AND SPREAD LEVEL
      4. DTS AND EXCESS RETURN VOLATILITY
      5. IMPLICATIONS OF DTS FOR PORTFOLIO MANAGERS
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
    7. Credit Spread Decomposition
      1. REVEALING THE DRIVERS OF CREDIT SPREADS
      2. CREDIT SPREAD DECOMPOSITION: MODEL SPECIFICATION AND IMPLEMENTATION
      3. INTERPRETING THE RESULTS OF THE CREDIT SPREAD DECOMPOSITION MODEL
      4. APPLICATIONS OF CREDIT SPREAD DECOMPOSITION
      5. ALTERNATIVE CREDIT SPREAD DECOMPOSITION MODELS
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
    8. Credit Derivatives and Hedging Credit Risk
      1. CREDIT PORTFOLIO MODELING: WHAT’S THE HEDGE?
      2. THE MERTON MODEL AND ITS VARIANTS: TRANSACTION-LEVEL HEDGING
      3. THE MERTON MODEL AND ITS VARIANTS: PORTFOLIO- LEVEL HEDGING
      4. CREDIT DEFAULT SWAPS AND HEDGING
      5. PORTFOLIO- AND TRANSACTION-LEVEL HEDGING USING TRADED MACROECONOMIC INDICES
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
  13. Derivatives Valuation
    1. No-Arbitrage Price Relations for Forwards, Futures, and Swaps
      1. UNDERSTANDING CARRY COSTS/BENEFITS
      2. VALUING FORWARDS
      3. VALUING FUTURES
      4. HEDGING WITH FUTURES
      5. SUMMARY
      6. IMPLYING FORWARD NET CARRY RATES
      7. VALUING SWAPS
      8. KEY POINTS
      9. NOTES
      10. REFERENCES
    2. No-Arbitrage Price Relations for Options
      1. OPTIONS AND FORWARDS
      2. CONTINUOUS RATES
      3. DISCRETE FLOWS
      4. NO-ARBITRAGE FUTURES OPTIONS RELATIONS
      5. NO-ARBITRAGE INTERMARKET RELATIONS
      6. KEY POINTS
      7. NOTES
      8. REFERENCES
    3. Introduction to Contingent Claims Analysis
      1. STATES OF THE WORLD
      2. CONTINGENT CLAIMS AND THEIR VALUE
      3. INVESTOR’S UTILITY MAXIMIZATION IN CONTINGENT CLAIMS MARKETS
      4. INCOMPLETE MARKETS FOR CONTINGENT CLAIMS
      5. FINANCIAL INSTRUMENTS AS CONTINGENT CLAIMS
      6. KEY POINTS
      7. REFERENCES
    4. Black-Scholes Option Pricing Model
      1. MOTIVATION
      2. BLACK-SCHOLES FORMULA
      3. COMPUTING A CALL OPTION PRICE
      4. SENSITIVITY OF OPTION PRICE TO A CHANGE IN FACTORS: THE GREEKS
      5. COMPUTING A PUT OPTION PRICE
      6. ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES MODEL AND BASIC EXTENSIONS
      7. BLACK-SCHOLES MODEL APPLIED TO THE PRICING OF OPTIONS ON BONDS: IMPORTANCE OF ASSUMPTIONS
      8. KEY POINTS
      9. References
    5. Pricing of Futures/Forwards and Options
      1. PRICING OF FUTURES/FORWARD CONTRACTS
      2. PRICING OF OPTIONS
      3. KEY POINTS
      4. REFERENCES
    6. Pricing Options on Interest Rate Instruments
      1. MODELING THE TERM STRUCTURE AND BOND PRICES
      2. MODELING IN PRACTICE
      3. HJM METHODOLOGY
      4. BOND OPTION PRICING
      5. PRACTICAL CONSIDERATIONS
      6. KEY POINTS
      7. REFERENCES
    7. Basics of Currency Option Pricing Models
      1. BASIC PROPERTIES
      2. THEORETICAL VALUATION
      3. BLACK-SCHOLES MODEL
      4. EXAMPLES OF OTHER MODELS
      5. PRICING WITHOUT A COMPUTER MODEL
      6. THE PRICE OF AN OPTION
      7. THE GREEKS
      8. KEY POINTS
      9. REFERENCES
    8. Credit Default Swap Valuation
      1. DEFAULT SWAPS
      2. CREDIT EVENTS
      3. PRICING CREDIT DEFAULT SWAPS BY STATIC REPLICATION
      4. PRICING OF A SINGLE-NAME CREDIT DEFAULT SWAP
      5. KEY POINTS
      6. NOTES
      7. REFERENCES
    9. Valuation of Fixed Income Total Return Swaps
      1. AN INTUITIVE APPROACH
      2. USING THE DUFFIE- SINGLETON MODEL
      3. THE FORWARD MEASURE
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    10. Pricing of Variance, Volatility, Covariance, and Correlation Swaps
      1. DESCRIPTION OF SWAPS
      2. MODELING AND PRICING OF VARIANCE, VOLATILITY, COVARIANCE, AND CORRELATION SWAPS WITH STOCHASTIC VOLATILITY
      3. NUMERICAL EXAMPLE: VOLATILITY SWAP FOR S&P60 CANADA INDEX
      4. KEY POINTS
      5. NOTES
      6. REFERENCES
    11. Modeling, Pricing, and Risk Management of Assets and Derivatives in Energy and Shipping
      1. ENERGY COMMODITY PRICE MODELS
      2. VALUATION AND HEDGING OF DERIVATIVES
      3. APPLICATIONS
      4. KEY POINTS
      5. REFERENCES
  14. Index