Fundamental Models in Financial Theory

by Doron Peleg

Overview

Understanding and applying complex modern financial models in real life scenarios, including the Black-Litterman model for constructing an optimal portfolio while incorporating personal views.

This book provides an innovative, integrated, and methodical approach to understanding complex financial models, integrating topics usually presented separately into a comprehensive whole. The book brings together financial models and high-level mathematics, reviewing the mathematical background necessary for understanding these models organically and in context. It begins with underlying assumptions and progresses logically through increasingly complex models to operative conclusions. Readers who have mastered the material will gain the tools needed to put theory into practice and incorporate financial models into real-life investment, financial, and business scenarios.

Modern finance's most bothersome shortcoming is that the two basic models for building an optimal investment portfolio, Markowitz's mean-variance model and Sharpe and Treynor's Capital Asset Pricing Model (CAPM), fall short when we try to apply them using Excel Solver. This book explores these two models in detail, and for the first time in a textbook the Black-Litterman model for building an optimal portfolio constructed from a small number of assets (developed at Goldman Sachs) is thoroughly presented. The model's integration of personal views and its application using Excel templates are demonstrated. The book also offers innovative presentations of the Modigliani–Miller model and the Consumption-Based Capital Asset Pricing Model (CCAPM). Problems at the end of each chapter invite the reader to put the models into immediate use. Fundamental Models in Financial Theory is suitable for classroom use or as a reference for finance practitioners.

Product Details

ISBN-13:	9780262026673
Publisher:	MIT Press
Publication date:	03/27/2014
Series:	The MIT Press
Pages:	496
Product dimensions:	6.10(w) x 9.00(h) x 1.10(d)
Age Range:	18 Years

About the Author

Doron Peleg has worked in both academia and industry. He has taught Finance and Entrepreneurial Management at institutions of higher education including Hunter and Lehman colleges in New York City and Tel Aviv and Tel Hai colleges in Israel.

Table of Contents

Foreword xi

1 The Time Value of Capital 1

1 Introduction 3

A Models in Financial Theory 3

B The Company's Goals 7

C The CFO's Roles 8

D Basic Elements in Financial Planning 11

2 Building Blocks: Interest and Dividends-The Basic Model 13

A Interest as the Price of Money-Consumption Utility over Time 13

B The Company's Production Function-Investment, Profit, and Dividends 16

C Basic Capital Markets-Debt and Participation Certificates 20

D Primary Institutions in the Capital Market 24

Questions and Problems 27

3 Interest Rates 33

A Nominal and Effective Interest Rates 33

B Inflation and the Real Interest Rate 36

C Benchmark Interest Rate and Risk Premium 37

D The Term Structure of Interest Rates 41

E Interest Rates and the Stock Market 43

Questions and Problems 44

4 Valuation of Periodic Cash Flows 49

A Periodic Cash Flows 49

B Future Value of Fixed Cash Flows 50

C Present Value of Fixed Cash Flows 52

D Present Value of Perpetual Cash Flows 55

E Present Value of Variable Cash Flows 57

F Problems in Future Cash Flow Valuation 58

Questions and Problems 59

5 Fundamental Bond Valuation Models 63

A Yield and Risk 63

B Perfect Market-Valuing Financial Assets 64

C Basic Models for Bonds 67

D Bond Types and Generally Accepted Terminology 75

Questions and Problems 77

6 Fundamental Share Valuation Models-The Earnings Model and the Dividend Model 83

A Assumptions 83

B The Earnings Model 84

C The Dividend Model 88

D The Dividend Model-An Empirical Review 92

Questions and Problems 93

7 Fundamental Share Valuation Models-Modigliani and Miller's Cash Flow Model 101

A Assumptions 101

B Modigliani and Miller's Cash Flow Model 102

C Earnings, Dividend, and Cash Flow Models-Applications 108

Questions and Problems 111

8 Capital Budgeting-Corporate Investment Decision Criteria 115

A Investment in Physical Assets and New Projects 115

B Net Present Value as a Decision-Making Criterion 118

C Internal Rate of Return as a Decision-Making Criterion 118

D Other Decision-Making Tools as Criteria 120

E Ranking Investments-The Optimal Method 122

Questions and Problems 126

9 Capital Budgeting-Net Cash Flow Construction 133

A Net Cash Flow in a World with Taxes 133

B Projects with Different Durations 138

C Government Intervention 141

Questions and Problems 143

II The Risk Value of Capital 149

10 Investment Decisions in Random Markets 151

A Statistical Tools in Financial Theory 151

B Random Processes-Stochastic Dominance on the Payoff-Probability Plane 161

C Random Processes-Stochastic Dominance on the Mean Yield-Risk Plane 165

D Making Investment Decisions in a Random Market 167

Questions and Problems 168

11 Personal Preferences in Uncertain Markets 177

A The Utility Function under Uncertainty 177

B Risk Aversion on the Payoff-Utility Plane 184

C Absolute and Relative Risk Aversion 188

D Risk Aversion on the Mean Yield-Risk Plane 192

E Rational Decision Making-A Myth? 194

Questions and Problems 197

12 The Mean-Variance Model 203

A The Evolution of Portfolio Valuation Models 203

B Defining Risk for a Single Financial Asset 204

C Mean Return and Variance when Holding Two Risky Assets 207

D Assets' Correlation Effect on the Investment Opportunities Set 209

E Constructing a Multi-Asset Portfolio-The Investment Opportunities Set 215

F Constructing a Portfolio in a Market with a Risk-Free Asset 219

G Summary of the Markowitz Mean-Variance Model 221

Questions and Problems 223

13 The Capital Asset Pricing Model 231

A Observation-Beta as a Measure of Risk 231

B Building a CAPM Portfolio 236

C Comparing the Mean-Variance Model and the CAPM 241

D Portfolio Management-Performance Appraisals 244

E Empirical Testing 248

F Expanding the Market Model 253

Questions and Problems 256

14 Assembling a Practical Portfolio-Allocating a Few Assets 265

A Introduction 265

B Problems in Constructing a Portfolio with a Limited Number of Assets 269

C Review of Linear (Matrix) Algebra 274

D Optimal Portfolio Allocation 279

E The Normalized Variance-Covariance Matrix 284

F Optimal Portfolio Construction Using Excel 286

G The Investment Opportunities Line 294

Questions and Problems 296

15 Adding Subjective Views to Portfolio Allocation (the Black-Litterman Model) 301

A Introduction 301

B The Personal View Vector-Defining the Values of the Expected Returns 306

C Confidence in the Quality of Statistical Estimators 311

D The Personal View Vector-Defining the Variances of the Expected Returns 314

E Deriving [E(R)] and $$$ of the Joint Probability Distribution 317

F Adding Subjective Views Using Excel 323

G Summary and Conclusions for the New Investment Opportunities Line 330

16 Capital Structure-Maximizing Company Value 333

A Capital Structure Effects on Corporate Value-Introduction 333

B The Basic Assumptions and Model 336

C Tax Shelter-Modigliani and Miller's First Proposition 338

D Modigliani and Miller's First Proposition-Arbitrage 346

Questions and Problems 347

17 The Cost of Corporate Capital 355

A Risk and Returns in Corporate Capital Structure 355

B Corporate Business Park-The Classic Approach 358

C The Cost of a Company's Capital Sources-Modigliani and Miller's Second Proposition 364

D Corporate Business Park-Classic versus Modern Financial Theory 369

E The Cost of Capital-Capital Budgeting under Uncertainty 375

Questions and Problems 380

18 Risk Trading 385

A Pure Risk Trading-Future Contracts 385

B The Consumption-Based Capital Asset Pricing Model 392

C Hedging Interest and Currency Risk 395

D Hedging Equity Holding Risk 400

Questions and Problems 408

19 Option Pricing 415

A Statistical Tools 415

B Call Option Pricing 418

C Put Option Pricing 430

D Additional Applications of the Option's Model-Bonds 435

E Structured Product Pricing 437

F An Empirical Review 441

Questions and Problems 444

20 Summary, Insights, and Further Study 451

A Summary 451

B Insights 453

C Further Study 464

Index 471

What People are Saying About This

Yossi Yagil

Fundamental Models in Financial Theory by Doron Peleg incorporates a mathematical and systematic approach to key issues in finance. The theoretical models are simplified, making it possible and straightforward both to comprehend and apply them to real-life financial problems. The incorporation of Excel and end-of-chapter problems are excellent tools for understanding the issues analyzed in the textbook. Dr. Peleg's book can serve as an excellent source of knowledge for both academia and practitioners.

Eli Amir

Doron Peleg's Fundamental Models in Financial Theory provides a thorough understanding of finance models, combined with the tools needed to apply the theory in day-to-day financial decisions. While other texts in this field emphasize the theory, Peleg's book will be useful to students because it actually tells them how to apply the theory in practice.

Harry Markowitz

Doron Peleg's Fundamental Models in Financial Theory is unique in that it combines a thorough exposition of theory with questions as to how this theory is to be used in the field. Many other texts on financial theory explain relationships between securities and portfolios yet leave the reader to somehow make estimates concerning the parameters that characterize the joint distributions of individual security returns. Dr. Peleg's book faces up to this problem of making estimates—particularly estimates of expected returns for securities or asset classes—while delivering on its promise to cover from everything from theory to practice. It would not surprise me if Fundamental Models in Financial Theory becomes one of the best-selling textbooks in finance.

From the Publisher

Doron Peleg's Fundamental Models in Financial Theory is unique in that it combines a thorough exposition of theory with questions as to how this theory is to be used in the field. Many other texts on financial theory explain relationships between securities and portfolios yet leave the reader to somehow make estimates concerning the parameters that characterize the joint distributions of individual security returns. Dr. Peleg's book faces up to this problem of making estimates—particularly estimates of expected returns for securities or asset classes—while delivering on its promise to cover from everything from theory to practice. It would not surprise me if Fundamental Models in Financial Theory becomes one of the best-selling textbooks in finance.

— Harry Markowitz , 1990 Nobel Laureate, Economics

Doron Peleg's Fundamental Models in Financial Theory provides a thorough understanding of finance models, combined with the tools needed to apply the theory in day-to-day financial decisions. While other texts in this field emphasize the theory, Peleg's book will be useful to students because it actually tells them how to apply the theory in practice.

— Eli Amir , Professor of Accounting, Tel Aviv University and City University of London

Fundamental Models in Financial Theory by Doron Peleg incorporates a mathematical and systematic approach to key issues in finance. The theoretical models are simplified, making it possible and straightforward both to comprehend and apply them to real-life financial problems. The incorporation of Excel and end-of-chapter problems are excellent tools for understanding the issues analyzed in the textbook. Dr. Peleg's book can serve as an excellent source of knowledge for both academia and practitioners.

— Yossi Yagil , Professor of Finance, Dean of the Faculty of Management, University of Haifa

Endorsement

Fundamental Models in Financial Theory by Doron Peleg incorporates a mathematical and systematic approach to key issues in finance. The theoretical models are simplified, making it possible and straightforward both to comprehend and apply them to real-life financial problems. The incorporation of Excel and end-of-chapter problems are excellent tools for understanding the issues analyzed in the textbook. Dr. Peleg's book can serve as an excellent source of knowledge for both academia and practitioners.

—Yossi Yagil, Professor of Finance, Dean of the Faculty of Management, University of Haifa