Valuation model
Various
instruments are traded in the
financial markets.
For example, in the
fixed income markets
bonds,
bills,
notes and
zero coupon bonds are all bought and sold.
In the more widely known
equity markets, we find
shares - aka
stocks, in addition to perhaps various
options on these
underlying instruments.
Regardless of the market we are considering,
investors must have a
mechanism to determine the
fair value of something they are either buying or selling.
Such a mechanism - more commonly known as a
valuation model - is essential to insure that the markets are
liquid.
A valuation model is nothing more than a
formula or set of formulae and
rules that are applied to a given security in a specific situation, to calcuate the value of a financial instrument.
In many ways, a valuation model can be considered the
financial equivalent of an
algorithim.
Valuation models range from the rather simple
dividend growth horizon model which calcuates the fair value of a stock
now based upon investor expectations of it's possible future value, to the esoteric and more mathematically advanced
black-scholes model, which values derivative instruments such as
options.
Regardless of the simplicity or complexity of the algorithim used, it is important to understand that the ultimate purpose of a
valuation model is to determine the fair value of a
financial asset.