The Oxford Guide to Financial Modeling: Applications... (PDF) (2024)

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The Oxford Guide toFINANCIAL MODELING

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The Oxford Guide toFINANCIAL MODELINGApplications for Capital Markets, Corporate Finance,Risk Management, and Financial InstitutionsThomas S. Y. HoSang Bin LeeOXFORDUNIVERSITY PRESS2004

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OXTORDUNIVERSITY PRESSOxford New YorkAuckland Bangkok Buenos Aires Cape Town ChennaiDar es Salaam Delhi Hong Kong Istanbul Karachi KolkataKuala Lumpur Madrid Melbourne Mexico City Mumbai NairobiSao Paulo Shanghai Taipei Tokyo TorontoCopyright © 2004 by Thomas S. Y. Ho and Sang Bin LeePublished by Oxford University Press, Inc.198 Madison Avenue, New York, New York, 10016www.oup.comOxford is a registered trademark of Oxford University PressAll rights reserved. No part of this publication may be reproduced,stored in a retrieval system, or transmitted, in any form or by any means,electronic, mechanical, photocopying, recording, or otherwise,without the prior permission of Oxford University Press.Library of Congress Cataloging-in-Publication DataHo, Thomas S. Y.The Oxford guide to financial modeling : applications for capital markets, corporate finance,risk management and financial institutions / by Thomas Ho and Sang Bin Lee.p. cm.Includes bibliographical references.ISBN 0-19-516962-X1. Finance. 2. Finance—Case studies. 3. Derivative securities. 4. Derivative securities—Case studies. 5. Corporations—Finance. 6. Corporations—Finance—Case studies. I. Title:Financial modeling. II. Yi, Sang-bin. III. Title.HG173 .H5815 2004332'.01'1—dc22 20030187419 8 7 6 5 4 3 2 1Printed in the United States of Americaon acid-free paper

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In the middle of writing this book, the tragic events of September 11, 2001, occurred.When we looked out from our office, which was covered with gray ash, and saw thecollapsed World Trade Center and the devastation of Ground Zero, we came to realizethere is no effort that is too small to strengthen the awareness of peace among peoples.We dedicate this book to world peace.

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Prefaceith more than 20 years of financial experience each, we have seen financial mod-Weling play an ever-increasing role in financial markets. Option models were in-troduced to trading floors in the 1970s. Interest rate models were widely used in the1980s for fixed-income securities. At the same time, the growth of financial productsin this period led to the prevalent use of financial models in asset management. In the1990s, financial models became indispensable tools for fast-growing risk managementpractices.Starting with our earliest involvement, we considered financial modeling to be the artof finding the best quantitative solution to a business problem. Financial models are fastbecoming indispensable decision-support tools for trading, portfolio management, riskmanagement, corporate financing, financial planning, regulation, and so on. But what isfinancial modeling? What are the financial concepts (theories) behind the mathematicalalgorithms? How do we build financial models to provide business solutions? This bookis written to answer these questions and to address the needs of both practitioners andeducators in finance.This book is the outcome of our experiences in both the academic and the corporateworlds. These experiences include researching, teaching, developing, and implementingthe financial models that are the focus of this book. Throughout our academic careers,we have spent much of our time developing valuation models for financial securitiesand testing them empirically. We teach financial modeling in our academic classes as ascientific discipline, emphasizing the thinking process that is required to properly de-velop and use them. As practitioners, we have worked with the investment departmentsof financial institutions in areas of asset/liability management, corporate management,trading, and risk management. These experiences have enabled us to gain insight intohow various financial models can be and should be used in practice.We are aware of no other book that successfully ties the thought processes andapplications of the financial models together and describes them as one process whichprovides business solutions. Generally, financial textbooks segment the world of financeinto "investments," "financial institutions," "corporate finance," and "securities analysis,"and in so doing they rarely emphasize the relationships between the subjects. Recently,courses in financial engineering programs have evolved a fundamental raison d'etre morerooted in mathematics than in financial theories. The "practitioners' books" tend to focuson the how-to approach, as if there is always a manual for solving a financial problem.Surely, to understand financial modeling, don't we first need or want to see an overviewof the process, with a balanced perspective across the main disciplines of finance? Thisbook is written to fill this void.Once a graduate from a prestigious business school was overheard saying, "Financialmodeling is really quite simple. It is just about different variations of the Black-Scholes

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viii PREFACEmodel." Such a remark must have aroused a deep sense of disappointment and fear inacademics and practitioners alike. As academics, we are proud to have participated inthe successful growth of the subject of financial modeling, but this person reduced allthe accomplishments to "just different variations of the Black-Scholes model." As prac-titioners and educators in quantitative research, we fear that our financial engineers toooften focus on alternative mathematical models and not often enough on the thinkingprocess of modeling. As a result of emphasizing the techniques and not understandingthe broader context of a business problem, they may provide an erroneous or irrelevantsolution. Users of financial models must understand that financial modeling is a processfor providing business solutions. This process begins with understanding the businessproblem and posing the appropriate statement of the problem within the context of aquantitative analytical framework by specifying the assumptions of the model. Next, atheory or model is developed to address the problem. The model is then applied to thebusiness solution with empirical evidence.Despite the prevalent use and growing importance of financial models, most pub-lications are devoted to describing specific models, such as those for stocks, bonds, oroptions, or to their specific applications, such as arbitrage trading and portfolio manage-ment. Few books describe the financial principles behind the models and tie the modelsto business solutions. But those who employ financial models should know how eachmodel should be used as part of a whole. Otherwise, the potential use of models andthe development of modeling will be significantly limited. A key motivation for writingthis book is to describe financial modeling in this broader context. To understand sucha broader context, we believe one needs to understand financial problems in a coherentframework.It is our belief that financial modeling can only become more important to our finan-cial system. Although financial modeling is critical to so many aspects of our financialsystem, such as trading, hedge fund investments, and risk management, corporate man-agement is only beginning to use financial models. In our experience, few models areintegrated into the management of a firm, yet the use of financial models in corporatemanagement has vast potential.There are at least two reasons for the slow adoption of financial modeling in corporatefinance. A distinct failure to relate how valuations can be used in practice in classrooms,and how research can be directed to practical problems in corporate finance, is onereason. Another reason is that prevailing financial models have not been extended to dealwith corporate financial management issues, and thus fail to reach the attention of thecorporate senior management. For these reasons, there is a need for a book to explain thesignificant value of financial modeling applying to capital markets and corporate finance.It is our hope that this book will serve this need well.About the BookTheme and OrganizationThe essential premise of this book is that theory and practice are equally important indescribing financial modeling. We try to strike a balance in our discussions between thetheories that provide foundations for financial models and the institutional details thatprovide the context for applications of the models.

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PREFACE ixWe present the financial models of stock and bond options, exotic options, invest-ment-grade and high-yield bonds, convertible bonds, mortgage-backed securities, andliabilities of financial institutions. We also describe the applications of the models tocorporate finance, and we relate the models to financial statements, risk managementfor an enterprise, and asset/liability management with illiquid instruments. The businessmodel and the corporate model are used to provide the analyses.The book presents the progression of the financial models from option pricing inthe securities markets to firm valuation in corporate finance, following a format thatemphasizes the three aspects of a model: the set of assumptions, the model specification,and the model applications.• The set of assumptions describes the conceptual ideas behind the model, the circum-stances that the model may be applicable to, and the problem that the model seeksto evolve. In going through the assumptions of the models, readers gain insightinto the thought process behind the model.• The model specification is the mathematical description of the model showing howinput data are used to produce the quantitative results predicted by the model.The specification may be presented as a mathematical formula or as a step-by-stepprocedure of building a model.• Model applications show how each model is used or should be used in practice. Thefinancial models described in this book can further our understanding of financialtheories, and have direct and important applications in business.Black and Scholes's seminal 1973 article, "The Pricing of Options and CorporateLiabilities," is a milestone in the development of financial models. It proposed a newparadigm for valuing options and anticipated that the methodology can be extended tocorporate liabilities, as the title indicates. The organization of this book follows the flowof thoughts suggested by that paper and is divided into three parts.Part I, "Options," starts with the portfolio theory and ends with a broad array ofvaluation models of derivatives. The valuation models described include equity, bonds,and their options. Empirical results are provided to support the validity of these modelsand the implications of the models are discussed.Part II, "Corporate Liabilities," extends option pricing to corporate liabilities and theapplications of the model to the balance sheet items: corporate bonds, high-yieldsecurities, mortgage-backed bonds, convertible securities and other bond types, and theliabilities of financial institutions. These items are less liquid; some have no liquidmarket, if they are tradable at all. Yet the theory argues that the contingent claim theoryremains applicable to them. The valuation model is then shown to have importantimplications for the management of a firm's balance sheet.Part III, "Corporate Finance," further extends the analysis to valuing any firm. Theanalysis argues that a firm itself can be viewed as a security, a contingent claim on itsuncertain revenues. The valuation model is then used to describe corporate financialstrategies. The empirical testing of the model is provided. More important, the model ofa firm enables us to evaluate the effectiveness of some corporate financial decisions inincreasing shareholders' value.The formation of each building block is as self-contained as possible. Each chapterpresents the models and their usefulness in providing economic insights. Empiricalevidence and applications of the model are then provided. The appendix to each chapter