DLOM Finnerty (2012)

The Finnerty Average-Strike Put Option (2012) 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 2012 model requires three key inputs to estimate the Discount for Lack of Marketability (DLOM):

1. Time (T)

   Definition: Time, typically measured in years, represents the expected holding period of the shares or the period during which the shares are illiquid.

   Significance: In the Finnerty model, Time impacts the model similarly to how the expiration affects an option's value in traditional financial models. The longer the Time, the greater the potential for price fluctuation, which can affect the DLOM.

   Application: It is used to simulate the period over which a hypothetical investor is exposed to the illiquidity of the asset. For example, if an asset cannot be sold for a year, the Time input would be 1.00 years.

2. Expected Volatility (σ)

   Definition: Expected Volatility measures the expected annualized standard deviation of returns of the stock or asset. It represents the degree of variation or uncertainty of the asset's return over the Time to maturity.

   Significance: Volatility is a critical factor in option pricing models because it influences the risk associated with the price movements of the asset. Higher volatility increases the value of the put option used to estimate DLOM, as it suggests greater uncertainty and potential for adverse movements in the asset's price.

   Application: Determining the appropriate volatility can be challenging, especially for privately held shares that do not have market-traded equivalents. Often, analysts may look to comparable publicly traded companies or historical data to estimate this input.

3. Dividend Yield (q)

   Definition: Dividend Yield is the expected annual dividends as a percentage of the current stock price.

   Significance: In option pricing, dividends are relevant because they represent a return to the holder during the option's life. For DLOM calculations using options, dividends reduce the risk to the option holder, thereby potentially decreasing the option's value and thus the DLOM.

   Application: If the asset pays dividends, this yield must be factored into the model as it affects the underlying asset's expected return. For an asset that does not distribute dividends, this would typically be set to 0%.

Each of these inputs plays a critical role in the Finnerty model by influencing the estimation of the marketability discount through the theoretical lens of option pricing. Accurately estimating these parameters is crucial for appropriately valuing the DLOM, especially in contexts where assets lack liquidity, such as with privately held company shares.