Thursday, June 28, 2007

Valuation models get a Wharton banality stamp

The more exotic a financial product gets, harder is it to price. This has been recently confirmed by a Wharton study (you would’ve pooh-poohed it if someone as earthy as I had said that). All existing valuation models have their basis on historical price of a product and market dynamics are changing so fast that variables from the past can’t form the only basis. For eg.A common model input for valuing stock options is its future stock price volatility, essentially a call on underlying stock price. How accurate can it be? You have to make room for the new variables that sprout in future and guessing that is the hardest part.

This was in fact the dilemma that a recent Wharton roundtable tried to unravel.

I liked the remark made by Mark Carey of the Federal Reserve Board, in so far that it echoed what I had always maintained – “Fair values are unverifiable. Any model is an opinion embodying many judgments.” The best model is always a matter of opinion and the determinant can only be its market.

The takeaway? Nothing new. While financial modeling will continue to be controversial, it’ll keep getting better. The progression will be more towards evaluation by unbiased outsiders using those models than by the model designers.

Classical Whartonian ending on a note of hope. How convenient to leave all things open ended? When there’s nothing more to organize, reorganize. Couple of years later, same topic will resurface in the form of another conference, more subscription. Try reminding them of the earlier conference and its summation, well…that’s too low on priority. [Am I joining the larger chorus of bored ones out there?]

My limited intelligence favors Auctioning. It’s the ultimate acid test that stands taller than all other models. Power to the highest bidder. The bid factors in everything - intrinsic value, market perception of future prospects and above all the satisfaction that you didn't sell cheap. Market is God. Period.

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