DLOM Finnerty (2002)

The Finnerty Average-Strike Put Option (2002) model to calculate the Discount for Lack of Marketability (DLOM) as can be applicable in a Post-Vest Holding Period scenario. It assumes that the put option is struck at the average price of the stock over the period from valuation date to expiration date. The seller is not assumed to have any special market timing ability. We use FinTools Exotics XL to calculate the value of a put struck at the projected arithmetic mean of the share price over the life of the option, with exercise taking place on the date of expiration.

Function Description: The Finnerty 2002 model requires three key inputs to estimate the Discount for Lack of Marketability (DLOM):

1. Time (T)

   Definition: This represents the expected holding period of the shares, or the time until the shares can be freely sold, measured in years.

   Significance: Time in the Finnerty 2002 model serves a similar purpose as in the 2012 model, defining the duration over which the shares are considered illiquid. The longer the period, the higher the potential DLOM, as the liquidity risk increases with time.

   Application: It is used to represent the duration during which an investor is expected to hold onto the illiquid asset before it can be sold, directly affecting the risk and discount level applied in the DLOM calculation.

2. Expected Volatility (σ)

   Definition: This measures the annualized standard deviation of the percentage change in the asset's price, reflecting the asset's price variability over time.

   Significance: Expected Volatility is a critical determinant of the value of any option-based model, including the Finnerty 2002 model. High volatility increases the option's value, thereby increasing the estimated DLOM because the underlying asset's price can significantly deviate from its current level by the time it becomes marketable.

   Application: In practice, the volatility must often be estimated from comparable publicly traded companies or sector-based averages, especially for private companies that lack direct market pricing data.

3. Interest Rate (r)

   Definition: This is the risk-free rate corresponding to the maturity of the expected holding period.

   Significance: The risk-free rate is used in the model to discount future payments, reflecting the time value of money. In option models, it also affects the growth assumption of the underlying asset's price under a risk-neutral measure.

   Application: Typically, the interest rate used is that of a U.S. Treasury bond or bill that matches the holding period’s duration. This rate should reflect the current economic conditions and the baseline return that investors would expect from a completely risk-free investment over the same period.

4. Dividend Yield (q)

   Definition: This represents the annual dividends expected from the asset, expressed as a percentage of its current price.

   Significance: In option theory, the dividend yield affects the option's pricing by lowering the expected price of the asset at the end of the holding period. For DLOM calculations, a higher dividend yield can reduce the discount because it compensates the investor during the period of illiquidity.

   Application: For non-dividend-paying assets, this yield would be zero. For assets that do pay dividends, this input would be based on historical payouts and future expectations, properly annualized.

These inputs collectively allow the Finnerty 2002 model to simulate the conditions under which an illiquid asset would be held and eventually sold, incorporating the risk and return parameters to compute the DLOM accurately. Each parameter plays a vital role in capturing the financial characteristics and risks associated with holding illiquid securities.