Financial Modeling

Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment. Financial modeling is a general term that means different things to different users; the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications. While there has been some debate in the industry as to the nature of financial modeling—whether it is a tradecraft, such as welding, or a science—the task of financial modeling has been gaining acceptance and rigor over the years. Typically, financial modeling is understood to mean an exercise in either asset pricing or corporate finance, of a quantitative nature.

In corporate finance and the accounting profession, financial modeling typically entails financial statement forecasting; usually the preparation of detailed company-specific models used for decision making purposes and financial analysis.

Applications include:

  • Business valuation, especially discounted cash flow, but including other valuation problems
  • Scenario planning and management decision making
  • Capital budgeting
  • Cost of capital calculations
  • Financial statement analysis
  • Project finance

Modelers are sometimes referred to (tongue in cheek) as “number crunchers”, and are often designated “financial analyst”. Typically, the modeler will have completed an MBA orMSF with (optional) coursework in “financial modeling”. Accounting qualifications and finance certifications such as the CIIA and CFA generally do not provide direct or explicit training in modeling. At the same time, numerous commercial training courses are offered, both through universities and privately.

In quantitative finance, financial modeling entails the development of a sophisticated mathematical model. Models here deal with asset prices, market movements, portfolio returns and the like. A general distinction is between: “quantitative financial management”, models of the financial situation of a large, complex firm; “quantitative asset pricing”, models of the returns of different stocks; “financial engineering”, models of the price or returns of derivative securities; “quantitative corporate finance”, models of the firm’s financial decisions.

Relatedly, applications include:

  • Option pricing and calculation of their “Greeks”
  • Other derivatives, especially interest rate derivatives, credit derivatives and exotic derivatives
  • Modeling the term structure of interest rates (Bootstrapping, short rate modelling) and credit spreads
  • Credit scoring and provisioning
  • Corporate financing activity prediction problems
  • Portfolio optimization.[17]
  • Real options
  • Risk modeling (Financial risk modeling) and value at risk[18]
  • Dynamic financial analysis (DFA)
  • Pairs trading
  • Credit valuation adjustment, CVA, as well as the various XVA

These problems are generally stochastic and continuous in nature, and models here thus require complex algorithms, entailing computer simulation, advanced numerical methods(such as numerical differential equations, numerical linear algebra, dynamic programming) and/or the development of optimization models. The general nature of these problems is discussed under Mathematical finance, while specific techniques are listed under Outline of finance# Mathematical tools. For further discussion here see also: Financial models with long-tailed distributions and volatility clustering; Brownian model of financial markets; Martingale pricing; Extreme value theory; Historical simulation (finance). Modellers are generally referred to as “quants” (quantitative analysts), and typically have advanced (Ph.D. level) backgrounds in quantitative disciplines such as physics,engineering, computer science, mathematics or operations research. Alternatively, or in addition to their quantitative background, they complete a finance masters with a quantitative orientation, such as the Master of Quantitative Finance, or the more specialized Master of Computational Finance or Master of Financial Engineering; the CQF is increasingly common.