Financial Terms Factor model

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# Definition of Factor model

## Factor model

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

# Related Terms:

## Single factor model

A model of security returns that acknowledges only one common factor.
See: factor model.

## Two-factor model

Black's zero-beta version of the capital asset pricing model.

## One-factor APT

A special case of the arbitrage pricing theory that is derived from the one-factor model by
using diversification and arbitrage. It shows the expected return on any risky asset is a linear function of a
single factor.

## ADF (annuity discount factor)

the present value of a finite stream of cash flows for every beginning \$1 of cash flow.

## economic components model

Abramsâ€™ 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

Abramsâ€™ model to calculate discount rates as a function of the logarithm of the value of the firm.

## PPF (periodic perpetuity factor)

a generalization formula invented by Abrams that is the present value of regular but noncontiguous cash flows that have constant growth to perpetuity.

## QMDM (quantitative marketability discount model)

model for calculating DLOM for minority interests r the discount rate

## Amortization factor

The pool factor implied by the scheduled amortization assuming no prepayemts.

## Annuity factor

Present value of \$1 paid for each of t periods.

## Arbitrage-free option-pricing models

Yield curve option-pricing models.

## Asset pricing model

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

## Asset pricing model

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

## 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.

## 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.

## 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.

## Conversion factors

Rules set by the Chicago Board of Trade for determining the invoice price of each
acceptable deliverable Treasury issue against the Treasury Bond futures contract.

## Deterministic models

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

## Discount factor

Present value of \$1 received at a stated future date.

## Discounted dividend model (DDM)

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

## 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.

## 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

A financial institution that buys a firm's accounts receivables and collects the debt.

## Factor analysis

A statistical procedure that seeks to explain a certain phenomenon, such as the return on a
common stock, in terms of the behavior of a set of predictive factors.

## Factor portfolio

A well-diversified portfolio constructed to have a beta of 1.0 on one factor and a beta of
zero on any other factors.

## Factoring

Sale of a firm's accounts receivable to a financial institution known as a factor.

## Garmen-Kohlhagen option pricing model

A widely used model for pricing foreign currency options.

## Index model

A model of stock returns using a market index such as the S&P 500 to represent common or
systematic risk factors.

## Market model

This relationship is sometimes called the single-index model. The market model says that the
return on a security depends on the return on the market portfolio and the extent of the security's
responsiveness as measured, by beta. In addition, the return will also depend on conditions that are unique to
the firm. Graphically, the market model can be depicted as a line fitted to a plot of asset returns against
returns on the market portfolio.

## Maturity factoring

factoring arrangement that provides collection and insurance of accounts receivable.

## Modeling

The process of creating a depiction of reality, such as a graph, picture, or mathematical
representation.

## Multifactor CAPM

A version of the capital asset pricing model derived by Merton that includes extramarket
sources of risk referred to as factor.

## Net benefit to leverage factor

A linear approximation of a factor, T*, that enables one to operationalize the
total impact of leverage on firm value in the capital market imperfections view of capital structure.

## Old-line factoring

factoring arrangement that provides collection, insurance, and finance for accounts receivable.

## Pie model of capital structure

A model of the debt/equity ratio of the firms, graphically depicted in slices of
a pie that represent the value of the firm in the capital markets.

## Pool factor

The outstanding principal balance divided by the original principal balance with the result
expressed as a decimal. Pool factors are published monthly by the Bond Buyer newspaper for Ginnie Mae,
Fannie Mae, and Freddie Mac(Federal Home Loan Mortgage Corporation) MBSs.

## Present value factor

factor used to calculate an estimate of the present value of an amount to be received in
a future period.

## Reported factor

The pool factor as reported by the bond buyer for a given amortization period.

## Single index model

A model of stock returns that decomposes influences on returns into a systematic factor,
as measured by the return on the broad market index, and firm specific factors.

## Simple linear trend model

An extrapolative statistical model that asserts that earnings have a base level and
grow at a constant amount each period.

## Single-index model

Related: market model

## Stochastic models

Liability-matching models that assume that the liability payments and the asset cash flows
are uncertain. Related: Deterministic models.

## Two-state 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 it can take on in the preceding time period.
Also called the binomial option pricing model.

## Value-at-Risk model (VAR)

Procedure for estimating the probability of portfolio losses exceeding some
specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities.

## Yield curve option-pricing models

models that can incorporate different volatility assumptions along the
yield curve, such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing models.

## Limiting factor

The production resource that, as a result of scarce resources, limits the production of goods
or services, i.e. a bottleneck.

## Capital Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk

## critical success factors (CSF)

any item (such as quality, customer
service, efficiency, cost control, or responsiveness
to change) so important that, without it, the organization
would cease to exist

## Internet business model

a model that involves
(1) few physical assets,
(2) little management hierarchy, and
(3) a direct pipeline to customers

## Binomial model

A method of pricing options or other equity derivatives in
which the probability over time of each possible price follows a binomial
distribution. The basic assumption is that prices can move to only two values
(one higher and one lower) over any short time period.

## Black-Scholes model

The first complete mathematical model for pricing
options, developed by Fischer Black and Myron Scholes. It examines market
price, strike price, volatility, time to expiration, and interest rates. It is limited
to only certain kinds of options.

## Markowitz model

A model for selecting an optimum investment portfolio,
devised by H. M. Markowitz. It uses a discrete-time, continuous-outcome
approach for modeling investment problems, often called the mean-variance
paradigm. See Efficient frontier.

## Factoring

The sale of accounts receivable to a third party, with the third party bearing
the risk of loss if the accounts receivable cannot be collected.

All the costs incurred during the manufacturing process, minus the
costs of direct labor and materials.

## annuity factor

Present value of an annuity of \$1 per period.

## capital asset pricing model (CAPM)

Theory of the relationship between risk and return which states that the expected risk
premium on any security equals its beta times the market risk premium.

## constant-growth dividend discount model

Version of the dividend discount model in which dividends grow at a constant rate.

## discount factor

Present value of a \$1 future payment.

## dividend discount model

Computation of todayâ€™s stock price which states that share value equals the present value of all expected future dividends.

## percentage of sales models

Planning model in which sales forecasts are the driving variables and most other variables are
proportional to sales.

## Factor of Production

A resource used to produce a good or service. The main macroeconomic factors of production are capital and labor.

## Factoring

The discounting, or sale at a discount, of receivables on a nonrecourse, notification
basis. The purchaser of the accounts receivable, the factor, assumes full risk of collection and
credit losses, without recourse to the firms discounting the receivables. Customers are notified to
remit directly to the factor.

## Scrap factor

An anticipated loss percentage included in the bill of material and
used to order extra materials for a production run, in anticipation of scrap losses.

## Shrinkage factor

The expected loss of some proportion of an item during the
production process, expressed as a percentage.

## Factor

An agent who buys and sells goods on behalf of others for a commission.

## Factoring

Type of financial service whereby a firm sells or transfers title to its accounts receivable to a factoring company, which then acts as principal, not as agent.

## Interest Factor

Numbers found in compound interest and annuity tables. Usually called the FVIF or PVIF.

## fractional interest discount

the combined discounts for lack of control and marketability. g the constant growth rate in cash flows or net income used in the ADF, Gordon model, or present value factor.

## product cost

This is a key factor in the profit model of a business. Product
cost is the same as purchase cost for a retailer or wholesaler (distributor).
A manufacturer has to accumulate three different types of production
costs to determine product cost: direct materials, direct labor, and
manufacturing overhead. The cost of products (goods) sold is deducted
from sales revenue to determine gross margin (also called gross profit),
which is the first profit line reported in an external income statement
and in an internal profit report to managers.

## unit-driven expenses

Expenses that vary in close proportion to changes
in total sales volume (total quantities of sales). Examples of these types of
expenses are delivery costs, packaging costs, and other costs that depend
mainly on the number of products sold or the number of customers
served. These expenses are one of the key factors in a profit model for
decision-making analysis. Segregating these expenses from other types
of expenses that behave differently is essential for management decisionmaking
analysis. The cost-of-goods-sold expense depends on sales volume
and is a unit-driven expense. But product cost (i.e., the cost of
goods sold) is such a dominant expense that it is treated separately from
other unit-driven operating expenses.

## Implied volatility

For an option, the variance that makes a call option price
equal to the market price. Given the option price, strike price, and other
factors, the Black-Scholes model computes implied volatility.

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