Bahria University, Islamabad

Omar Safdar, CPA

 Market Valuation:
◦ The process of determining the current worth of a portfolio, company,
investment, or balance sheet item.

 Valuation of financial assets is done using one or

more of these types of models:
◦ Discounted Cash Flows determine the value by estimating the expected
future earnings from owning the asset discounted to their present value.
◦ Relative value models determine the value based on the market prices of
similar assets.
◦ Option pricing models are used for certain types of financial assets (e.g.,
warrants, put options, call options, employee stock options, investments
with embedded options such as a callable bond) and are a complex
present value model
 Opportunity cost of capital:
◦ is the expected return forgone by bypassing of other potential investment
activities for a given capital. It is a rate of return that investors could earn
in financial markets.

 Valuation is more an art than a science because it requires

judgment:

◦ There are very different situations and purposes in which you value an
asset (e.g. company in distress, tax purposes, mergers & acquisitions,
quarterly reporting). In turn this requires different methods or a different
interpretation of the same method each time.
◦ All valuation models and methods have their limitations (e.g.,
mathematical, complexity, simplicity, comparability) and could be widely
criticized. As a general rule the valuation models are most useful when you
use the same valuation method as the "partner" you are interacting with.
Mostly the method used is industry or purpose specific;

◦ The quality of some of the input data may vary widely

◦ In all valuation models there are a great number of assumptions that need
to be made and things might not turn out the way you expect. Your best
way out of that is to be able to explain and stand for each assumption you
make;

◦ When a valuation is prepared all assumptions should be clearly stated,

especially the context. It is improper, for example, to value a going
concern, based on an assumption that it is going out of business, since
then only a salvage value remains.
 Valuation of a distressed company

 Additional adjustments to a valuation approach, whether it is market-,

income- or asset-based, may be necessary in some instances. These involve:

 excess or restricted cash other non-operating assets and liabilities

 lack of marketability discount

 control premium or lack of control discount

 above or below market leases

 excess salaries in the case of private companies.

 Valuation of intangible assets

◦ Valuation models can be used to value intangible assets such as patents,

copyrights, software, trade secrets, and customer relationships. Since few
sales of benchmark intangible assets can ever be observed, one often
values these sorts of assets using either a present value model or
estimating the costs to recreate it. Regardless of the method, the process
is often time consuming and costly.
 Asset pricing models
◦ Capital asset pricing model (CAPM)
 A model that describes the relationship between risk and expected return and that
is used in the pricing of risky securities.
 The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk.

◦ Arbitrage pricing theory (APT)

 is a general theory of asset pricing, that has become influential in the pricing of
stocks. APT holds that the expected return of a financial asset can be modeled as
a linear function of various macro-economic factors or theoretical market indices,
where sensitivity to changes in each factor is represented by a factor-specific beta
coefficient.
◦ Black-Scholes (for options)
 The Black–Scholes model is a mathematical description of financial markets and
derivative investment instruments. The model develops partial differential
equations whose solution, the Black–Scholes formula, is widely used in the pricing
of European-style options.

◦ Single-index model
 is a simple asset pricing model commonly used in the finance industry to measure
risk and return of a stock.

◦ Markov Switching Multifractal

 is a model of asset returns that incorporates stochastic volatility components of
heterogeneous durations. MSM captures the outliers, log-memory-like volatility
persistence and power variation of financial returns
 Arbitrage pricing theory (APT)
◦ the concept has to do with the process of asset pricing.
Essentially, the arbitrage pricing theory, or APT for short, helps to
establish the price model for various shares of stock.
 Arbitrage pricing theory (APT)
◦ the underlying principle of the pricing theory involves the recognition
that the anticipated return on any asset may be charted as a linear
calculation of relevant macro-economic factors in conjunction with
market indices. It is expected that there will be some rate of change in
most if not all of the relevant factors. Running scenarios using this
model helps to arrive at a price that is equitable to the anticipated
performance of the asset.

◦ The desired result is that the asset price will equal to the anticipated
price for the end of the period cited, with the end price discounted at the
rate implied by the Capital Asset Pricing Model. It is understood that if
the asset price gets off course, that arbitrage (the simultaneous buying
and selling of the same negotiable financial instruments or commodities
in different markets in order to make an immediate profit without risk)
will help to bring the price back into reasonable perimeters.
 APT MODEL
 Idiosyncratic Risk: The risk of price change due to the unique
circumstances of a specific security, as opposed to the overall
market. This risk can be virtually eliminated from a portfolio through
diversification, also called unsystematic risk.

 The APT states that if asset returns follow a factor structure then the
following relation exists between expected returns and the factor
sensitivities:

 That is, the expected return of an asset j is a linear (straight Line)

function of the assets sensitivities to the n factors.
 Black–Scholes Model Assumptions:
◦ It is possible to borrow and lend cash at a known constant risk-free interest rate.
This restriction has been removed in later extensions of the model.

◦ The price follows a Geometric Brownian motion with constant drift and volatility. This
often implies the validity of the efficient-market hypothesis.

◦ There are no transaction costs or taxes.

◦ Returns from the security follow a Log-normal distribution.

◦ The stock does not pay a dividend

◦ All securities are perfectly divisible (i.e. it is possible to buy any fraction of a share).

◦ There are no restrictions on short selling.

◦ There is no arbitrage opportunity

◦ Options use the European exercise terms, which dictate that options may only be
exercised on the day of expiration.
 Black–Scholes Formula:
 S, the price of the stock
 V(S,t), the price of a derivative as a function of time and stock price.
 C(S,t) the price of a European call
 P(S,t) the price of a European put option.
 K, the strike of the option.
 r, the annualized risk-free interest rate, continuously compounded.
 μ, the drift rate of S, annualized.
 σ, the volatility of the stock; this is the square root of the quadratic
variation of the stock's log price process.
 t a time in years; we generally use now = 0, expiry = T.
 Π, the value of a portfolio.
 R, the accumulated profit or loss following a delta-hedging trading
strategy.
 Black–Scholes Formula:
 Black–Scholes Model Assumptions:
 Black–Scholes Formula:
 Single-Index Model (SIM) :
 a simple asset pricing model commonly used in the
finance industry to measure risk and return of a stock.
Mathematically the SIM is expressed as:
 Single-Index Model (SIM):
 rit is return to stock i in period t
 rf is the risk free rate (i.e. the interest rate on treasury bills)
 rmt is the return to the market portfolio in period t
 αi is the stock's alpha, or abnormal return
 βi is the stocks's beta, or responsiveness to the market return
 Note that rit − rf is called the excess return on the stock, rmt − rf the
excess return on the market
 εit is the residual (random) return, which is assumed normally
distributed with mean zero and standard deviation σi
 Assumptions of the single-Index Model
 that there is only 1 macroeconomic factor that causes
the systematic risk affecting all stock returns and this
factor can be represented by the rate of return on a
market index, such as the S&P 500

 According to this model, the return of any stock can be

decomposed into the expected excess return of the
individual stock due to firm-specific factors, commonly
denoted by its alpha coefficient, the return due to
macroeconomic events that affect the market, and the
unexpected microeconomic events that affect only the
firm.
◦ The term βi(rm − rf) represents the movement of the
market modified by the stock's beta, while ei
represents the unsystematic risk of the security due
to firm-specific factors.

◦ In a portfolio, the unsystematic risk due to firm-

specific factors can be reduced to zero by
diversification.
 Basis of Index Model:
 Most stocks have a positive covariance because they all
respond similarly to macroeconomic factors.

 However, some firms are more sensitive to these

factors than others, and this firm-specific variance is
typically denoted by its beta (β), which measures its
variance compared to the market for one or more
economic factors.
 Basis of Index Model:
 Covariances among securities result from differing
responses to macroeconomic factors. Hence, the
covariance of each stock can be found by multiplying
their betas and the market variance.

 Cov(Ri, Rk) = βiβkσ2. This last equation greatly

reduces the computations required to determine
covariance because otherwise the covariance of the
securities within a portfolio must be calculated using
historical returns, and the covariance of each possible
pair of securities in the portfolio must be calculated
independently
 Markov-Switching Multifractal (MSM):
◦ is a model of asset returns that incorporates stochastic volatility
components of heterogeneous durations.

◦ MSM captures the outliers, log-memory-like volatility persistence

and power variation of financial returns.

◦ In currency and equity series, MSM compares favorably with

standard volatility models such as GARCH and FIGARCH.

◦ MSM is used by practitioners in the financial industry to forecast

volatility, compute value-at-risk, and price derivatives.