Financial Valuation Modeling in a Nutshell: Dilution, Diversification and Hedging

POSTED — January 29, 2014 — Opinions

Every couple of years I make some attempt to condense the principles of financial modeling:

All securities bear risk.

The essential problem of financial modeling is to determine the expected return that goes with a given estimated (future) risk.

To determine the expected return of a given risky security, note that there are three ways of lowering its risk:

  1. Dilution: combining the security with a riskless bond;

  2. Diversification: combining the security with other uncorrelated securities;

  3. Hedging; combining the security with another anti-correlated security to cancel one aspect of its risk.

If by these means you can lower the estimated risk of a portfolio that contains the security to zero, it is logical that you should expect to earn the return of a riskless bond, assumed known. The expected return of the given security can then be pinned down from this constraint. 

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All of this is perfectly reasonable a priori. Where it fails in real life is that one cannot estimate risk correctly.

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