Fundamental Models in Financial Theory

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.

Table of Contents

Part I The Time Value of Capital
Chapter 1 Introduction
Chapter 2 Building Blocks: Interest and Dividends — The Basic Model
Chapter 3 Interest Rates
Chapter 4 Valuation of Periodic Cash Flows
Chapter 5 Fundamental Bond Valuation Models
Chapter 6 Fundamental Share Valuation Models — The Earnings Model and the Dividend Model
Chapter 7 Fundamental Share Valuation Models — Modigliani and Miller’s Cash Flow Model
Chapter 8 Capital Budgeting — Corporate Investment Decision Criteria
Chapter 9 Capital Budgeting — Net Cash Flow Construction

Part II The Risk Value of Capital
Chapter 10 Investment Decisions in Random Markets
Chapter 11 Personal Preferences in Uncertain Marke
Chapter 12 The Mean-Variance Model
Chapter 13 The Capital Asset Pricing Model
Chapter 14 Assembling a Practical Portfolio — Allocating a Few Assets
Chapter 15 Adding Subjective Views to Portfolio Allocation (the Black-Litterman Model)
Chapter 16 Capital Structure — Maximizing Company Value
Chapter 17 The Cost of Corporate Capital
Chapter 18 Risk Trading
Chapter 19 Option Pricing
Chapter 20 Summary, Insights, and Further Study