Definition of Monte Carlo simulation

Monte Carlo simulation

An analytical technique for solving a problem by performing a large number of trail
runs, called simulations, and inferring a solution from the collective results of the trial runs. Method for
calculating the probability distribution of possible outcomes.

Monte-Carlo simulation

A mathematical modeling process. For a model that
has several parameters with statistical properties, pick a set of random values
for the parameters and run a simulation. Then pick another set of values, and
run it again. Run it many times (often 10,000 times) and build up a statistical
distribution of outcomes of the simulation. This distribution of outcomes is
then used to answer whatever question you are asking.

Simulation

The use of a mathematical model to imitate a situation many times in order to estimate the
likelihood of various possible outcomes. See: monte carlo simulation.

simulation analysis

Estimation of the probabilities of different possible outcomes, e.g., from an investment project.

economic components model

Abrams’ model for calculating DLOM based on the interaction of discounts from four economic components.
This model consists of four components: the measure of the economic impact of the delay-to-sale, monopsony power to buyers, and incremental transactions costs to both buyers and sellers.

Gordon model

present value of a perpetuity with growth.
The end-ofyear Gordon model formula is: 1/(r - g)
and the midyear formula is: SQRT(1 + r)/(r - g).

log size model

Abrams’ model to calculate discount rates as a function of the logarithm of the value of the firm.

markup

the period after an announcement of a takeover bid in which stock prices typically rise until a merger or acquisition is made (or until it falls through).

QMDM (quantitative marketability discount model)

model for calculating DLOM for minority interests r the discount rate

runup

the period before a formal announcement of a takeover bid in which one or more bidders are either preparing to make an announcement or speculating that someone else will.

Acquisition of assets

A merger or consolidation in which an acquirer purchases the selling firm's assets.

Agency problem

Conflicts of interest among stockholders, bondholders, and managers.

Arbitrage-free option-pricing models

Yield curve option-pricing models.

Asset

Any possession that has value in an exchange.

Asset/equity ratio

The ratio of total assets to stockholder equity.

Asset/liability management

Also called surplus management, the task of managing funds of a financial
institution to accomplish the two goals of a financial institution:
1) to earn an adequate return on funds invested, and
2) to maintain a comfortable surplus of assets beyond liabilities.

Asset activity ratios

Ratios that measure how effectively the firm is managing its assets.

Asset allocation decision

The decision regarding how an institution's funds should be distributed among the
major classes of assets in which it may invest.

Asset-backed security

A security that is collateralized by loans, leases, receivables, or installment contracts
on personal property, not real estate.

Asset-based financing

Methods of financing in which lenders and equity investors look principally to the
cash flow from a particular asset or set of assets for a return on, and the return of, their financing.

Asset classes

Categories of assets, such as stocks, bonds, real estate and foreign securities.

Asset-coverage test

A bond indenture restriction that permits additional borrowing on if the ratio of assets to
debt does not fall below a specified minimum.

Asset for asset swap

Creditors exchange the debt of one defaulting borrower for the debt of another
defaulting borrower.

Asset pricing model

A model for determining the required rate of return on an asset.

Asset substitution

A firm's investing in assets that are riskier than those that the debtholders expected.

Asset substitution problem

Arises when the stockholders substitute riskier assets for the firm's existing
assets and expropriate value from the debtholders.

Asset swap

An interest rate swap used to alter the cash flow characteristics of an institution's assets so as to
provide a better match with its iabilities.

Asset turnover

The ratio of net sales to total assets.

Asset pricing model

A model, such as the Capital Asset Pricing model (CAPM), that determines the required
rate of return on a particular asset.

Assets

A firm's productive resources.

Assets requirements

A common element of a financial plan that describes projected capital spending and the
proposed uses of net working capital.

Automated Clearing House (ACH)

A collection of 32 regional electronic interbank networks used to
process transactions electronically with a guaranteed one-day bank collection float.

Back-up

1) When bond yields and prices fall, the market is said to back-up.
2) When an investor swaps out of one security into another of shorter current maturity he is said to back up.

Bank for International Settlements (BIS)

An international bank headquartered in Basel, Switzerland, which
serves as a forum for monetary cooperation among several European central banks, the Bank of Japan, and the
U.S. Federal Reserve System. Founded in 1930 to handle the German payment of World War I reparations, it
now monitors and collects data on international banking activity and promulgates rules concerning
international bank regulation.

Bankruptcy

State of being unable to pay debts. Thus, the ownership of the firm's assets is transferred from
the stockholders to the bondholders.

Bankruptcy cost view

The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.

Bankruptcy risk

The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.

Bankruptcy view

The argument that expected bankruptcy costs preclude firms from being financed entirely
with debt.

Bargain-purchase-price option

Gives the lessee the option to purchase the asset at a price below fair market
value when the lease expires.

Base probability of loss

The probability of not achieving a portfolio expected return.

Binomial option pricing model

An option pricing model in which the underlying asset can take on only two
possible, discrete values in the next time period for each value that it can take on in the preceding time period.

Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.

Block house

Brokerage firms that help to find potential buyers or sellers of large block trades.

Book runner

The managing underwriter for a new issue. The book Runner maintains the book of securities sold.

Bottom-up equity management style

A management style that de-emphasizes the significance of economic
and market cycles, focusing instead on the analysis of individual stocks.

Builder buydown loan

A mortgage loan on newly developed property that the builder subsidizes during the
early years of the development. The builder uses cash to buy down the mortgage rate to a lower level than the
prevailing market loan rate for some period of time. The typical buydown is 3% of the interest-rate amount
for the first year, 2% for the second year, and 1% for the third year (also referred to as a 3-2-1 buydown).

Buy limit order

A conditional trading order that indicates a security may be purchased only at the designated
price or lower.
Related: Sell limit order.

Buyout

Purchase of a controlling interest (or percent of shares) of a company's stock. A leveraged buy-out is
done with borrowed money.

Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.

Capitalization method

A Method of constructing a replicating portfolio in which the manager purchases a
number of the largest-capitalized names in the index stock in proportion to their capitalization.

Cash settlement contracts

Futures contracts, such as stock index futures, that settle for cash, not involving
the delivery of the underlying.

Clearing House Automated Payments System (CHAPS)

A computerized clearing system for sterling funds
that began operations in 1984. It includes 14 member banks, nearly 450 participating banks, and is one of the
clearing companies within the structure of the Association for Payment Clearing Services (APACS).

Clearing House Interbank Payments System (CHIPS)

An international wire transfer system for high-value
payments operated by a group of major banks.

Clearing house / Clearinghouse

An adjunct to a futures exchange through which transactions executed its floor are settled by a
process of matching purchases and sales. A clearing organization is also charged with the proper conduct of
delivery procedures and the adequate financing of the entire operation.

Closing purchase

A transaction in which the purchaser's intention is to reduce or eliminate a short position in
a stock, or in a given series of options.

Collective wisdom

The combination of all of the individual opinions about a stock's or security's value.

Commission house

A firm which buys and sells future contracts for customer accounts. Related: futures
commission merchant, omnibus account.

Constant-growth model

Also called the Gordon-Shapiro model, an application of the dividend discount
model which assumes (1) a fixed growth rate for future dividends and (2) a single discount rate.

Continuous random variable

A random value that can take any fractional value within specified ranges, as
contrasted with a discrete variable.

Corporate processing float

The time that elapses between receipt of payment from a customer and the
depositing of the customer's check in the firm's bank account; the time required to process customer
payments.

Coupon

The periodic interest payment made to the bondholders during the life of the bond.

Coupon equivalent yield

True interest cost expressed on the basis of a 365-day year.

Coupon payments

A bond's interest payments.

Coupon rate

In bonds, notes or other fixed income securities, the stated percentage rate of interest, usually
paid twice a year.

Cross-border risk

Refers to the volatility of returns on international investments caused by events associated
with a particular country as opposed to events associated solely with a particular economic or financial agent.

Cumulative probability distribution

A function that shows the probability that the random variable will
attain a value less than or equal to each value that the random variable can take on.

Current assets

Value of cash, accounts receivable, inventories, marketable securities and other assets that
could be converted to cash in less than 1 year.

Current coupon

A bond selling at or close to par, that is, a bond with a coupon close to the yields currently
offered on new bonds of a similar maturity and credit risk.

Current rate method

Under This currency translation Method, all foreign currency balance-sheet and income
statement items are translated at the current exchange rate.

Current-coupon issues

Related: Benchmark issues

Customary payout ratios

A range of payout ratios that is typical based on an analysis of comparable firms.

Day order

An order to buy or sell stock that automatically expires if it can't be executed on the day it is entered.

Deterministic models

Liability-matching models that assume that the liability payments and the asset cash
flows are known with certainty. Related: Compare stochastic models

Diffusion process

A conception of the way a stock's price changes that assumes that the price takes on all
intermediate values. dirty price. Related: full price

Direct estimate method

A Method of cash budgeting based on detailed estimates of cash receipts and cash
disbursements category by category.

Direct stock-purchase programs

The purchase by investors of securities directly from the issuer.

Discounted dividend model (DDM)

A formula to estimate the intrinsic value of a firm by figuring the
present value of all expected future dividends.

Discrete random variable

A random variable that can take only a certain specified set of discrete possible
values - for example, the positive integers 1, 2, 3, . . .

Distributions

Payments from fund or corporate cash flow. May include dividends from earnings, capital
gains from sale of portfolio holdings and return of capital. Fund distributions can be made by check or by
investing in additional shares. Funds are required to distribute capital gains (if any) to shareholders at least
once per year. Some Corporations offer Dividend Reinvestment Plans (DRP).

Dividend discount model (DDM)

A model for valuing the common stock of a company, based on the
present value of the expected cash flows.

Dividend growth model

A model wherein dividends are assumed to be at a constant rate in perpetuity.

Dividend payout ratio

Percentage of earnings paid out as dividends.

Dow Jones industrial average

This is the best known U.S.index of stocks. It contains 30 stocks that trade on
the New York Stock Exchange. The Dow, as it is called, is a barometer of how shares of the largest
U.S.companies are performing. There are thousands of investment indexes around the world for stocks,
bonds, currencies and commodities.

Dupont system of financial control

Highlights the fact that return on assets (ROA) can be expressed in terms
of the profit margin and asset turnover.

Dynamic asset allocation

An asset allocation strategy in which the asset mix is mechanistically shifted in
response to -changing market conditions, as in a portfolio insurance strategy, for example.

Economic order quantity (EOQ)

The order quantity that minimizes total inventory costs.

Evening up

Buying or selling to offset an existing market position.

Exchange of assets

Acquisition of another company by purchase of its assets in exchange for cash or stock.

Extrapolative statistical models

models that apply a formula to historical data and project results for a
future period. Such models include the simple linear trend model, the simple exponential model, and the
simple autoregressive model.

Factor model

A way of decomposing the factors that influence a security's rate of return into common and
firm-specific influences.

Feasible set of portfolios

The collection of all feasible portfolios.

Feasible target payout ratios

Payout ratios that are consistent with the availability of excess funds to make
cash dividend payments.

Field warehouse

Warehouse rented by a warehouse company on another firm's premises.

Fill or kill order

A trading order that is canceled unless executed within a designated time period.
Related: open order.

Financial assets

Claims on real assets.

Fixed asset

Long-lived property owned by a firm that is used by a firm in the production of its income.
Tangible fixed assets include real estate, plant, and equipment. Intangible fixed assets include patents,
trademarks, and customer recognition.

Fixed asset turnover ratio

The ratio of sales to fixed assets.

Floating supply

The amount of securities believed to be available for immediate purchase, that is, in the
hands of dealers and investors wanting to sell.

Flow-through method

The practice of reporting to shareholders using straight-line depreciation and
accelerated depreciation for tax purposes and "flowing through" the lower income taxes actually paid to the
financial statement prepared for shareholders.

Frequency distribution

The organization of data to show how often certain values or ranges of values occur.

Full coupon bond

A bond with a coupon equal to the going market rate, thereby, the bond is selling at par.

Full-payout lease

See: financial lease.

Garmen-Kohlhagen option pricing model

A widely used model for pricing foreign currency options.

Give up

The loss in yield that occurs when a block of bonds is swapped for another block of lower-coupon
bonds. Can also be referred to as "after-tax give up" when the implications of the profit or loss on taxes are
considered.

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