Valuation model

Various instruments are traded in the financial markets.

For example, in the fixed income markets bonds, bills, notes and zero coupon bonds are all bought and sold.

In the more widely known equity markets, we find shares - aka stocks, in addition to perhaps various options on these underlying instruments.

Regardless of the market we are considering, investors must have a mechanism to determine the fair value of something they are either buying or selling.

Such a mechanism - more commonly known as a valuation model - is essential to insure that the markets are liquid.

A valuation model is nothing more than a formula or set of formulae and rules that are applied to a given security in a specific situation, to calcuate the value of a financial instrument.

In many ways, a valuation model can be considered the financial equivalent of an algorithim.

Valuation models range from the rather simple dividend growth horizon model which calcuates the fair value of a stock now based upon investor expectations of it's possible future value, to the esoteric and more mathematically advanced black-scholes model, which values derivative instruments such as options.

Regardless of the simplicity or complexity of the algorithim used, it is important to understand that the ultimate purpose of a valuation model is to determine the fair value of a financial asset.

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