Financial Python

Studies in Finance and Python

Monte carlo and fundamental analysis

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A recent discussion about stock options and the creation of Trefis (and it's ability to model firm value in a friendly way) made me wonder: Why isn't monte carlo isn't used more often in standard valuation models? Every b-school graduate has used @Risk or Crystal Ball, so associating probability distributions to revenue, expense, and other model drivers should be vaguely familiar at least.

This occurred to me because Trefis has a "crowdsourcing" feature that allows users to share their valuations with each other. If one could extract the driving assumptions from all these models (assuming there area lot of them for a given firm), I imagine the resulting valuation distribution might approximate a monte carlo model a single analyst might come up with.

But why do this? Growth estimates (e.g. sales, expenses, etc.) reflect an analyst's opinion about the stock, right? If you don't believe your valuation and outlook, what's the point? By articulating a risk profile for a given valuation, one is forced to consider the risk picture more broadly. Even if your expected valuation agrees with the last trading price, the risk profile of the valuation can still be used (via options) to account for other potential outcomes. One could even compare the "fundamental" risk profile with that implied by stock options to determine whether there are meaningful differences in opinion. I know Bloomberg has implemented the variance-gamma option model that allows analysts to extract a return distribution that takes into account the implied volatility skew. Combining this with a Black-Litterman exercise to estimate returns for a given portfolio (e.g. S&P500) might make for some interesting analysis.

For example, I imagine a portfolio manager might apply the Black Litterman approach to the SP500 and determine where the firm's fundamental analysts diverge meaningfully from returns implied by the current 'optimal' index pricing/weighting. By adding a risk profile layer to this basic analysis using monte carlo, the portfolio manager might find ways to trade a portfolio of options more effectively than simply buying or selling the underlying stock as he attempts to trade into his optimal exposures. Indeed, even if the firm's fundamental analysts agree completely with the returns implied by the Black-Litterman exercise, the individual firm risk profiles could suggest some micro or macro hedging via individual stock options or index options.

One concern is term mismatch. Stock options are short-dated options whereas fundamental analysts typically (or should I say allegedly?) look for fundamental value to be realized over a longer term (years vs. weeks or months). I suppose one could look at LEAPs, but I'm not sure how practical it is to trade those longer-dated contracts.

Anyway, food for a future notetoself. Maybe I just ate too much thai food.

Written by DK

January 22, 2010 at 2:28 am

Posted in Finance

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