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Financial Modeling and Analysis
A CUSTOMIZED TECHNOLOGY FOR FINANCIAL, INVESTMENT, AND RISK INTELLIGENCE
Worapot Ongkrutaraksa
For my dearest wife, Yorsri
Third Edit ion
Financial Modeling and Analysis
A CUS TOMI ZED TECHNOLOGY F OR FI NANCI AL, I NVES TMENT, AND RI S K I NTEL LI GENCE
Worapot Ongkrutaraksa, Ph.D.
Third Edit ion
T A B L E O F C O N T E N T S
Table of Contents
F O R E W O R D vii
Preface ix
Objectives of the Book............................................................ ix
Organization of the Book........................................................xii
Expectations from the Book...................................................xiv
About the Author.................................................................... xv
Acknowledgements ...............................................................xvi
C H A P T E R 1
I nt roduct ion t o Financial Modeling 1
From Financial Models to Business Intelligence...................... 1
Objective Matrix of Business Intelligence ................................ 2
Information Flows in Business Intelligence.............................. 7
Essential Spreadsheet Functions .......................................... 10
Model 1A: Cash Account Model ............................................ 23
Model 1B: Income Tax Model ................................................ 27
Model 1C: Rates Matrix Model .............................................. 31
C H A P T E R 2
Analysis of Time Value of Money 33
Future Value and Compounding Process.............................. 33
Present Value and Discounting Process ............................... 35
Variations in Compounding and Discounting......................... 35
Discounted Cash Flow Valuation........................................... 39
Model 2A: Time Value of Money Model ................................. 41
Model 2B: Loan Amortization Model ...................................... 45
Model 2C: Retirement Account Model ................................... 51
C H A P T E R 3
Analysis of Discount Rat es 55
Firm-based Discount Rates .................................................. 56
Market-based Discount Rates ............................................... 58
Weighted Average Cost of Capital......................................... 61
Model 3A: Dividend Discount Model ...................................... 63
Model 3B: Capital Asset Pricing Model.................................. 67
C H A P T E R 4
Analysis of Business Value 73
Business Valuation Approaches............................................ 73
Value Drivers of Business Enterprises.................................. 78
Valuation and Creditor Riskiness .......................................... 78
Valuation and Investor Riskiness .......................................... 79
Model 4A: Earnings per Share Model ................................... 81
Model 4B: Relative Valuation Model ..................................... 89
Model 4C: Intrinsic Valuation Model...................................... 93
C H A P T E R 5
Analysis of Financial St at ement s 99
Purposes of Financial Reports .............................................. 99
Standardized Financial Statements..................................... 100
Reformulated Financial Statements .................................... 103
Key Performance Indicators................................................ 106
Model 5A: Performance Evaluation Model .......................... 109
Model 5B: Pro Forma Statements Model ............................ 119
C H A P T E R 6
Analysis of Capit al I nvest ment s 131
Types of Investment Opportunities...................................... 131
Uses and Limitations of Capital Budgeting.......................... 133
Investment Decision-making Process ................................. 134
Modeling Technique for Capital Budgeting ......................... 135
Impacts of Financing Decisions on Value .......................... 140
Model 6A: Capital Budgeting Model .................................... 144
Model 6B: Capital Structure Model...................................... 149
C H A P T E R 7
Analysis of Port folio I nvest ment s 157
Return and Risk Measures of Financial Assets................... 157
Theory of Portfolio Selection and Investments.................... 159
Risky Asset Allocation and Portfolio Optimization............... 167
Model 7A: Risky Asset Portfolio Model ............................... 169
Model 7B: Portfolio Optimization Model .............................. 175
Financial Modeling and Analysis v Third Edit ion
T A B L E O F C O N T E N T S
C H A P T E R 8
Analysis of Fixed I ncome Securit ies 179
Determinants of Market Interest Rates................................ 179
Theory of Interest Rates and Bond Yields........................... 180
Using Yields to Forecast Future Short Rates ...................... 182
Bond Price Sensitivity, Durations, and Convexity................ 183
Using Duration to Immunize Bond Portfolio Returns ........... 186
Model 8A: Bond Valuation Model ........................................ 191
Model 8B: Bond Durations Model ........................................ 183
Model 8C: Bond Yields Model ............................................. 195
C H A P T E R 9
Analysis of Forwards, Fut ures & Swaps 203
Distinctions between Forward and Futures ......................... 203
Forward Price and Forward Contract Valuation................... 204
Futures Price and Futures Contract Valuation..................... 207
Risk Management and Hedging Strategies ......................... 210
Return Enhancement and Arbitrage Strategies ................... 212
Forward Rate Agreements and Interest Rate Swaps .......... 215
Balance Sheet Management and Swap Strategies ............. 227
Model 9A: Forward Pricing Model........................................ 233
Model 9B: Hedging Transactions Model .............................. 239
Model 9C: Interest Rate Swaps Model ................................ 231
C H A P T E R 1 0
Analysis of Opt ions & Cont ingent Claims 249
Contingent Claim Fundamentals ......................................... 249
Contingent Claim Valuation Concept................................... 251
Financial Option Contracts .................................................. 254
Real Option Analysis ........................................................... 256
Alternative Option Pricing Models........................................ 258
Empirical Evidence of Option Mispricing ............................. 267
Model 10A: Replication Option Pricing Model ..................... 269
Model 10B: Delta-ratio Option Pricing Model....................... 273
Model 10C: Risk-neutral Option Pricing Model .................... 279
Model 10D: Binomial Option Pricing Model ......................... 281
Model 10E: Black-Scholes-Merton Model............................ 285
C H A P T E R 1 2
Analysis of Financial Risks 287
Stochastic Diffusion Processes........................................... 287
SDP Applications in Risk Measurement.............................. 289
Asset Price and Return Simulations.................................... 294
Value-at-Risk Measures...................................................... 297
Credit Risk Measures.......................................................... 298
Model 11A: Returns Simulation Model ................................ 305
Model 11B: Value-at-Risk Model......................................... 311
Model 11C: Credit Risk Model............................................. 317
C H A P T E R 1 3
Epilogue t o Financial Modeling 323
What We Have Learned So Far .......................................... 323
What We Should Do Next ................................................... 324
Chartered Financial Analyst (CFA
).................................... 325
Financial Risk Manager (FRM
).......................................... 327
Academic Programs in Advanced Finance ......................... 328
Closing Remarks................................................................. 330
B I B L I O G R A P H Y 331
I N D E X 341
Financial Modeling and Analysis vi Third Edit ion
Foreword
This book introduces essential concepts, applications, and techniques in financial, investment, and risk
intelligence yet takes an unorthodox approach to its readers. By directly practicing on and interacting
with spreadsheet exercises that are packaged for easy understanding and maneuvering, the readers will
have an opportunity to discover, and a flexibility to consult, the theory and evidence leading to any
particular financial problem discussed herein or from other texts in the field. This on-the-job-training
approach is analogous to learning how to communicate in a foreign language for the first time by
actively mingling with local people and being assimilated into their culture instead of passively going
through a series of grammatical lessons first. A novice would gradually become a fluent practitioner
equipped with different flexible ways to cultivate her quantitative and computational finance
knowledge while enhancing her financial modeling and business-solution development skills.
The first use of this book is to assist the readers to jump-start their business and financial analysis
careers by integrating this newly acquired knowledge and skills in financial modeling with their relevant
business backgrounds. Accountants who traditionally collect, record, and report operating and
financial data from their companies business activities could now perform advanced and more
sophisticated analyses on valuation, investment, and risk management. Operation, distribution, and
marketing managers whose production, logistic, and sale targets depend on the estimate of customer
demands in different geographical areas and seasonal periods, or consumer preferences that are closely
tied with their demographical profiles, could also perform various types of quantitative and statistical
analysis through spreadsheet modeling similar to many practice exercises demonstrated in this book.
Most importantly, the book allows its audience to be less reliant on any formal lecture without sacrificing
the classrooms rigor yet gain more control over their study pace and learning development.
To a group of practitioners in the professional world, this book would help unify the team members
interests to focus on the business and modeling problems at hand. In a consulting firm, for example,
specific clients cases can be addressed based on their objectives, input data, and interface requirements
within the constraints of their resource and timetables, combined with diverse experiences of the team
members in problem prognosis and situational analysis as well as their expertise in intelligence
gathering, data-mining and warehousing, and design of and training for customized business solutions.
All they need to do is ascertain that coordination between the client and the team as well as among the
team members themselves is carried out in a cost-effective manner. Like an instruction manual, this
book shall direct the firms coordination efforts by keeping track of the progress of the teams tasks in
terms of what has been left out and which of them need to be accomplished along the priority list.
Those who intend to employ this book as part of their finance instructions and training modules
within the academic institution or professional setting will find it quite easy to adopt because the book
encapsulates the main finance topics that are regularly taught everywhere. The benefit of assigning this
book to the students lies on skill-building modeling exercises that will help in their preparation before
attending classes and their review afterwards. Various technical problems they have encountered
during their practices can be shared with and resolved through their instructors and classmates. Rather
than providing unilateral lectures all the time, the instructors could welcome and entertain their
students questions and comments while still focusing on relevant topics. When it comes to group or
individual project assignments, the students will be able to apply different models they have practiced
to their own projects without requiring constant assistance from their instructors. The expectations of
both the instructors and students will be more aligned and better fine-tuned to each other.
Clearly, the use of this book is not limited to just the above audiences it intends to serve. It is also
recommended to any individual who would like to approach finance differently and gain insights into
how to implement many finance formulae to exploit the vast opportunities in todays financial markets.
Financial Modeling and Analysis vii Third Edit ion
O B J E C T I V E S O F T H E B O O K
Preface
Objectives of the Book
ongratulations for making a prudent decision to invest your money in this book.
You can envisage how to profit from it by quickly browsing through its chapters.
It is fair to present to you here the formal objectives of the book as they are
intended in relation to your search for cutting-edge financial technology that is made easy
to understand and practice, as well as how it might help in adding value to your
professional endeavors.
C
What You Will Learn from This Book
There are two sets of learning outcomes you will gain from Financial Modeling and Analysis.
First is the linkage between finance theories and their applications, which includes:
Financial Measurement As an owner of business enterprise or a corporate manager
acting on behalf of shareholders, your responsibilities are planning, managing, and
making decisions on various operating, investment, and financing activities in order to
maximize the market value of your company. Despite your extensive experiences, you
still need a set of proven tools and techniques to assist you in ascertaining that your
decisions are prudent. Financial models represent such measurement tools that allow
you to try out your alternative strategies on different business and market scenarios.
Practically, you could construct a pro forma statements model to see the impacts on the
firms future performance from a change in one or more value-added programs. You
could use a capital budgeting model to evaluate the feasibility of your investment proposal,
be it a start-up project or a merger deal. You could also utilize a capital structure model to
choose the least-cost financing arrangement from among competing corporate loans
and security issues. In combination, you would expect the models to help confirm
your prior beliefs by factoring every aspect of business and market possibilities into
your calculated decision-making processes to ascertain that every dimension of your
strategic and tactical formulations has been tested against those possibilities.
Investment Measurement As an investor or a manager of an investment fund, your
function is to ensure that the total return on your portfolio investment is at least equal
to the return on a passively held yet well-diversified market portfolio. Since your
investment decisions are closely tied with the movements in market prices of different
asset classes, your prerogative is to thoroughly know the behavior of those asset prices
in order to estimate their future likelihood and impact on your portfolios total return.
To measure returns, you need to be well versed in various types of valuation models
like dividend discount model, capital asset pricing model, bond yields model, forward pricing model,
and option pricing models, which are standard techniques found in most finance books.
Financial Modeling and Analysis ix Third Edit ion
O B J E C T I V E S O F T H E B O O K P R E F A C E
The quantitative tools that enable you to study the behavior of risky assets under
normal market circumstances include stochastic diffusion models, simulation models, and
various families of probability and distribution models. Finally, portfolio optimization model
would allow you to construct a dynamically optimal portfolio that takes into account
assets cross-sectional returns and their intertemporal movements. Altogether, these
models are performed to help you observe the overall risk-return profiles of your
investments and execute your well-informed trading decisions with greater confidence.
Risk Measurement As a corporate risk manager or a financial engineer, your task is
to quantify the extent, and harness the severity, of business and financial risks to which
your company or clients are exposed. As market structures and composites change
due to unanticipated shifts in demand or supply, each event would magnify the severity
of risk manifold. To help them make better decisions, you need to acquire an in-depth
knowledge of derivative instruments, risk-quantification tools, and risk-management
techniques so that those exposures can be priced accurately and mitigated promptly.
In quantifying financial risk, you can approach its categories properly, including market
risk, credit risk, and operational risk. Market risk arises from random changes in asset
prices that result in liquidity losses from spot-price differentials and basis losses
from forward-price differentials. Credit risk leads to a loss of the entire investment due
to the counterpartys default, which is induced by either market risk or operational risk
faced by that counterparty. Operational risk is engendered from within the firm as a
result of failure to effectively monitor and control market risk and credit risk.
To capture market risk, you could utilize a value-at-risk model with such controllable
parameters as target critical value or target probability of loss. You could extend it into
a credit risk model to measure the default risk of a loan given the credit-rating profiles of
borrowers and their actuarial probabilities of default. Both models serve corporate risk
managers or financial engineers to provide valuable intelligence and recommendations
to their recipients in an accurate and timely manner.
The second set of learning outcomes involves an acquisition of practical skill in analytical
and computerized modeling that comprises:
Financial Model Planning Your initial task as a financial analyst is to map out a plan
for your financial models. This planning stage involves: 1) the identification of
financial problems within the scope of your business context; 2) the specification of
modeling objectives that uniquely and straightforwardly address your financial
problems; 3) the selection and classification of the relevant input variables and
database for the models; and 4) the design of financial models with proper objective
structures and information flows that would produce the desired output results. The
conceptual framework for financial model planning is thoroughly discussed in
Chapter 1 along with a few preliminary modeling exercises on which you can practice.
Spreadsheet Model Building After the planning stage, you will be ready to build
your own financial model on a computer platform. Traditionally, the models are
constructed as a series of mathematical and statistical equations that require manual
calculations and perhaps some additional manipulations and transformations. With
todays computer technology, we have been able to construct and implement those
traditional mathematical and statistical models on the so-called spreadsheet applications.
One of the more popular spreadsheet applications is Microsoft