Various Financial Models - Essay Example

Order #193253 Finance Financial modeling It is the process of developing financial depiction of a given set of factors that affect the firm or any investment option to be undertaken or already undertaken by the company. Financial modeling involves performing in depth calculation which will enable the management to make sound decisions based on the results of the calculations. The ability of the financial models to provide accurate information is paramount in that they are used when deciding on which project the company should invest in. With the advent of technology and computer, many models nowadays are calculated and evaluated using computer software which makes the whole process easy and faster. It is a fact that in a competitive world, companies should be able to make fast, timely and accurate investment decisions. But this is not to say that financial modeling cannot be performed manually. Types of financial models There are various financial models that a company can use in evaluating its investment projects. The only challenge for the company is to identify the model that will provide the most accurate information that can help the company make the right decision. Some of there models include Value- at- risk models, Interest rate models, Equity pricing models, Asset allocation models, Trading models, Investment portfolio models that can be used on equity or derivatives, Business simulation models that include Monte Carlo simulation and binary free and genetic algorithms used in optimization decisions. There are other various models under the above headings. Value-at-risk model (VaR) This is a model of calculating the probability of a collection of investment securities generating returns more than the anticipated. It is a model of analyzing past market performance, security correlation and the security movements. A basic value-at-risk model involves all types of market uncertainties e.g. interest, stock, goods and currency risks. It enables the determination of an estimate on the value of portfolio risk (maximum loss) based on the past performance of the portfolio at a given rate of certainty. The various models under the value-at-risk include the variance-covariance method, historical simulation and Monte Carlo simulation models. Variance-covariance It uses past values of security movements and relationship to determine the estimate of the future loses that could occur. Security movements and security relationship risk is calculated for a given period of time. Historical simulation models It generates a lot of results of the security value. It uses security risk and their associated probabilities to generate these results which are used to estimate the value of VaR. Interest rate models Some of the most commonly used interest rate financial models are the Black-Derman-Toy (BDT) model, Black -Karainsky (BK) model, Heath- Jarrow-Morton (HJM) model and the White-Hull model, Black-Derman-Toy Interest Rate Model It is mainly used for determining the value of derivatives by considering a preliminary zero rate term structure and the movement of the yield by constructing a tree explaining the interest rates. This model can also be a single-factor or multi-factor. The Heath-Jarrow-Morton model It uses statistical data and processes to derive the value of the derivatives by considering preliminary zero rate term structure and the up and down movement of future rates. Hull-white model It is a single factor that uses the preliminary term structure of interest rates with the up and down movement term structure to construct a trinomial free of short rates. Equity pricing models One of the widely used equity pricing model is the Capital Assets Pricing Model developed by William Sharpe and John Litner. It works on the premise that the return of a given security is affected by the risk called systematic. This risk is measured using beta () and it cannot be diversified away by holding a portfolio of securities. This model evolved from the portfolio theory which did not consider the systematic risk. The capital assets pricing model can be used to estimate the expected returns of a security and the cost of capital of a company. ERj=RF+j (Rm-Rf) Where ERj= expected return of security j Rf= Risk free rate Rm=return of the market Asset allocation models Asset allocation is the division of the available resources to be invested in to different investments which can be shares, fixed interest bonds, mutual funds, properties, derivatives, futures, option etc The aim is to minimize the risk involved with the portfolio as much as possible by investing in assets in the different sectors the economy which are not positively correlated. To achieve the optimum assets allocation, investment managers or companies use assets allocation models which largely depend on the risk profile of the investors and investment objectives i.e. short run or long run, high risk tolerant or low risk tolerant. Some of the assets allocation models that are used by investment firms are the preservation of capital, income, balanced and growth. Growth model This is used for those investors whose objectives are long term i.e. they invest for the future. These types of investors are those who have other streams of income and really don't depend on the investment alone. The assets usually appreciate in the long term and in case any dividend is paid, it is reinvested. Balance assets allocation model This asset allocation model is used in allocating investments which are for medium term. It a combination of income generating and those assets that are expected to appreciate. Usually is a mix of stocks and investments whose incomes are fixed e.g. bonds Income model The investments in this type of model are largely designed to provide a constant sum of income to the investor. This means that the investors are only interested in earning an income. The investments in this model include REITS, stocks and bonds Preservation of capital The investors here are risk averse and do not want to lose their investments hence they invest in derivatives, futures, swaps, options, bonds and commercial paper. These forms of investments guarantee a fixed income with the refund of capital at the end of the investment period. Trading financial models The most commonly used trading financial model is the systematic investment plan (SIP). In this method, the investments are made on a consistent regular basis. The objective here is for the investors to get maximum returns from the average buy price effect. The draw back of this method is that it only works well the long term. Business simulation models Monte Carlo simulation is widely used in many analyses. Monte Carlo involves the random use of numbers and probability to generate a wide range of solutions to problems. The advantage of Monte Carlo simulation method is that it is able to generate all probable results for a given situation and hence better decision making. Investment portfolio models These models are used to calculate the returns of the various portfolios in respect of risk. Some of the commonly used models are the Markowitz modern portfolio theory, CAPM, arbitrage pricing theory, Jensen ratio, Treynor ratio, value-at-risk model and the Sharpe diagonal model. Need for financial model importance In many cases, cash flow from investments e.g. equity or bond yields are not known with certainly meaning that we cannot accurately predict the performance of there investments. Financial models help the investors and investment companies predict the behavior of investments cash flow in the future. Financial models also help the investors to estimate the risks and returns associated with their investments. Investors want a stable and predictable investment climate and with these models, they are able to gauge the performance of the markets. The other important use of financial models is their ability to predict the expected returns to mitigate the risks and uncertainties involved in an investment. Futures Is a standardized financial contract that gives the buyer the obligation and right to buy an understated financial asset or goods at a specified future date and an earlier agreed price and quantity. These contracts also give the seller the obligation to sell. The advantage of futures is that they are standardized and hence can be traded in the futures market. Future can be used to hedge against any price fluctuation and thus reducing the risk. London futures London futures are traded in the London International Futures Exchange (LIFFE). LIFFE formed a partnership with the Chicago Futures Trade in 1987. This helped in the trading of futures in a 24 hour environment. The LIFFE largely traded in Bunds which are the 10 years German government bonds. The LIFFE was taken over by Euronext in 2002 and changed its name to Euronext LIFFE. Some of the major financial contracts in LIFFE are the Gilts, Short sterling Euribor and FTSE index while the commodities traded are white sugar, coffee, cocoa and feed wheat. Euronext takeover of LIFFE and the subsequent merger in 2007 with NYSE has created a wide market and range of products. The list of affiliated members includes the London, Amsterdam, Paris, Lisbon and Brussels futures markets. The best option The best option for the company is use the interest rate financial models to evaluate the uncertainties that face this kind of project. Some of the models include the Black-Derman-Toy (BDT), Black- Karainsky (BK) and the Health-Jarrow-Morton (HJM) models. The company is faced with the long wait of the announcement of the winner of the bid. This is one of the risks faced by the company. The company is also faced with the foreign exchange risk because it wants to receive the money in terms of Pounds and not Euros. The foreign exchange risks likely to be faced by the company are the transaction exposure, operating exposure and accounting exposure. Transaction risk estimates the movements of the unpaid obligations that were involved by the company before the change in interest rates while operating risk evaluates the fair value change of the company occasioned by movement of cash flows as a result of unforeseen interest rate change. The transaction risk measures the changes in the future cash flow on the short term while the operating exposure measures the changes in cash flow due to foreign competition. Accounting exposure occurs due to the changes in the shareholders wealth brought about by the translation of the currency in to the reporting currency. All these risks can be mitigated by hedging. Hedging involves acquiring an investment that will change from the current position e.g. by rising or failing. The company can therefore hedge against the interest rate fluctuation by entering in to a forward contract as it reduces the variance in future cash flows thus minimizing financial problems. Works cited Brazelton K J Ammons J L Enron and Beyond: Technical analysis of Accounting, Corporate Governance and . . . Accounting for Derivatives CCH (2002) page 59-77 Beenhakker H L The Global Economy and international financing. Managing Foreign exchange Exposure. Quorum/Greenwood 2001 page 149-152 Philips L Commodity, Futures and Financial Markets Springer page 36-42 Varchulova T Rimarcik M Value at Risk methods and their applications Volume xi University of Economics in Bratislava Benninga S Value at Risk Financial Modeling Second Edition MIT Press 2000 chapter 12 James J Webber N Interest rate Modeling Part ii John Willey & Sons 2000 Kennon J Asset allocation model About.Inc 2007 retrieved from http://beginnersinvest.about.com/od/assetallocation1/a/aa102404.htm Tang Y Li B Asset Trading model- Quantitative Analysis, derivatives modeling and Trading strategies in the presence of counter party credit risk for Fixed Income Market. World Scientific Publishing 2007 Wittwer, J.W., "Monte Carlo Simulation Basics" From Vertex42.com, June 1, 2004, http://vertex42.com/ExcelArticles/mc/MonteCarloSimulation.html Palmgren B The need for Financial models. ERCIM News no.38 July 1999 from http://www.ercim.org/publication/Ercim_News/enw38/palmgren.html Read More