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Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a
mathematical model A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used in the natural sciences (such as physics, ...
designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business,
project A project is any undertaking, carried out individually or collaboratively and possibly involving research or design, that is carefully planned to achieve a particular goal. An alternative view sees a project managerially as a sequence of even ...
, or any other investment. Typically, then, financial modeling is understood to mean an exercise in either asset pricing or corporate finance, of a quantitative nature. It is about translating a set of hypotheses about the behavior of markets or agents into numerical predictions. At the same time, "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 Science is a systematic endeavor that Scientific method, builds and organizes knowledge in the form of Testability, testable explanations and predictions about the universe. Science may be as old as the human species, and some of the earli ...
—the task of financial modeling has been gaining acceptance and rigor over the years.


Accounting

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 Financial analysis (also known as financial statement analysis, accounting analysis, or analysis of finance) refers to an assessment of the viability, stability, and profitability of a business, sub-business or project. It is performed by profe ...
. Applications include: *
Business valuation Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing ...
and stock valuation - especially via
discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate deve ...
, but including other valuation approaches *
Scenario planning Scenario planning, scenario thinking, scenario analysis, scenario prediction and the scenario method all describe a strategic planning method that some organizations use to make flexible long-term plans. It is in large part an adaptation and gene ...
and management decision making ("what is"; "what if"; "what has to be done" §39 "Corporate Planning Models". See also, §294 "Simulation Model".) * Capital budgeting, including
cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate n ...
(i.e. WACC) calculations * Financial statement analysis /
ratio analysis In mathematics, a ratio shows how many times one number contains another. For example, if there are eight oranges and six lemons in a bowl of fruit, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ...
(including of operating- and finance leases, and R&D) *Revenue related:
forecasting Forecasting is the process of making predictions based on past and present data. Later these can be compared (resolved) against what happens. For example, a company might estimate their revenue in the next year, then compare it against the actual ...
,
analysis Analysis ( : analyses) is the process of breaking a complex topic or substance into smaller parts in order to gain a better understanding of it. The technique has been applied in the study of mathematics and logic since before Aristotle (3 ...
* Project finance modeling * Cash flow forecasting *Credit decisioning: Credit analysis, Consumer credit risk; impairment- and
provision Provision(s) may refer to: * Provision (accounting), a term for liability in accounting * Provision (contracting), a term for a procurement condition * ''Provision'' (album), an album by Scritti Politti * A term for the distribution, storing and ...
-modeling * Working capital- and treasury management; asset and liability management *Management accounting:
Activity-based costing Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore, this model assigns more i ...
,
Profitability analysis In cost accounting, profitability analysis is an analysis of the profitability of an organisation's output. Output of an organisation can be grouped into products, customers, locations, channels and/or transactions. Description In order to per ...
, Cost analysis, Whole-life cost To generalize as to the nature of these models: firstly, as they are built around
financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
s, calculations and outputs are monthly, quarterly or annual; secondly, the inputs take the form of "assumptions", where the analyst ''specifies'' the values that will apply in each period for external / global variables ( exchange rates, tax percentage, etc....; may be thought of as the model ''
parameter A parameter (), generally, is any characteristic that can help in defining or classifying a particular system (meaning an event, project, object, situation, etc.). That is, a parameter is an element of a system that is useful, or critical, when ...
s''), and for internal / company specific ''variables'' (
wages A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', '' prevailing wage'', and ''yearly bonuses,'' and remuner ...
, unit costs, etc....). Correspondingly, both characteristics are reflected (at least implicitly) in the mathematical form of these models: firstly, the models are in
discrete time In mathematical dynamics, discrete time and continuous time are two alternative frameworks within which variables that evolve over time are modeled. Discrete time Discrete time views values of variables as occurring at distinct, separate "po ...
; secondly, they are deterministic. For discussion of the issues that may arise, see below; for discussion as to more sophisticated approaches sometimes employed, see and . Modelers are often designated "
financial analyst A financial analyst is a professional, undertaking financial analysis for external or internal clients as a core feature of the job. The role may specifically be titled securities analyst, research analyst, equity analyst, investment analyst, o ...
" (and are sometimes referred to ( tongue in cheek) as "number crunchers"). Typically, the modeler will have completed an MBA or MSF 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. For the components and steps of business modeling here, see ; see also for further discussion and considerations. Although purpose-built
business software Business software (or a business application) is any software or set of computer programs used by business users to perform various business functions. These business applications are used to increase productivity, measure productivity, and perf ...
does exist (see also Fundamental Analysis Software), the vast proportion of the market is
spreadsheet A spreadsheet is a computer application for computation, organization, analysis and storage of data in tabular form. Spreadsheets were developed as computerized analogs of paper accounting worksheets. The program operates on data entered in ce ...
-based; this is largely since the models are almost always company-specific. Also, analysts will each have their own criteria and methods for financial modeling.
Microsoft Excel Microsoft Excel is a spreadsheet developed by Microsoft for Windows, macOS, Android and iOS. It features calculation or computation capabilities, graphing tools, pivot tables, and a macro programming language called Visual Basic for ...
now has by far the dominant position, having overtaken
Lotus 1-2-3 Lotus 1-2-3 is a discontinued spreadsheet program from Lotus Software (later part of IBM). It was the first killer application of the IBM PC, was hugely popular in the 1980s, and significantly contributed to the success of IBM PC-compatible ...
in the 1990s. Spreadsheet-based modelling can have its own problems, and several standardizations and "
best practice A best practice is a method or technique that has been generally accepted as superior to other known alternatives because it often produces results that are superior to those achieved by other means or because it has become a standard way of doing ...
s" have been proposed.Best Practice
European Spreadsheet Risks Interest Group
"Spreadsheet risk" is increasingly studied and managed; see model audit. One critique here, is that model ''outputs'', i.e. line items, often inhere "unrealistic implicit assumptions" and "internal inconsistencies". (For example, a forecast for growth in revenue but without corresponding increases in working capital, fixed assets and the associated financing, may imbed unrealistic assumptions about asset turnover, debt level and/or equity financing. See .) What is required, but often lacking, is that all key elements are explicitly and consistently forecasted. Related to this, is that modellers often additionally "fail to identify crucial assumptions" relating to ''inputs'', "and to explore what can go wrong". Here, in general, modellers "use point values and simple arithmetic instead of probability distributions and statistical measures" — i.e., as mentioned, the problems are treated as deterministic in nature — and thus calculate a single value for the asset or project, but without providing information on the range, variance and sensitivity of outcomes; see . A further, more general critique relates to the lack of basic
computer programming Computer programming is the process of performing a particular computation (or more generally, accomplishing a specific computing result), usually by designing and building an executable computer program. Programming involves tasks such as anal ...
concepts amongst modelers, with the result that their models are often poorly structured, and difficult to maintain. (Serious criticism is also directed at the nature of budgeting, and its impact on the organization; see .)


Quantitative finance

In quantitative finance, ''financial modeling'' entails the development of a sophisticated
mathematical model A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used in the natural sciences (such as physics, ...
. 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 Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathe ...
", 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" ( accommodating
volatility surface Volatility smiles are implied volatility patterns that arise in pricing financial options. It is a parameter (implied volatility) that is needed to be modified for the Black–Scholes formula to fit market prices. In particular for a given expi ...
s - via local / stochastic volatility models - and multi-curves) *Other
derivatives The derivative of a function is the rate of change of the function's output relative to its input value. Derivative may also refer to: In mathematics and economics *Brzozowski derivative in the theory of formal languages *Formal derivative, an ...
, especially interest rate derivatives, credit derivatives and exotic derivatives *Modeling the term structure of
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
s (
bootstrapping In general, bootstrapping usually refers to a self-starting process that is supposed to continue or grow without external input. Etymology Tall boots may have a tab, loop or handle at the top known as a bootstrap, allowing one to use fingers ...
/ multi-curves, short-rate models, HJM framework) and any related credit spread * Credit valuation adjustment, CVA, as well as the various XVA * Credit risk, counterparty credit risk, and regulatory capital: EAD, PD, LGD, PFE, EE * Structured product design and manufacture * Portfolio optimization and Quantitative investing more generally; see further re optimization methods employed. * Financial risk modeling:
value at risk Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
( parametric- and / or historical,
CVaR Expected shortfall (ES) is a risk measure—a concept used in the field of financial risk measurement to evaluate the market risk or credit risk of a portfolio. The "expected shortfall at q% level" is the expected return on the portfolio in the ...
, EVT),
stress testing Stress testing (sometimes called torture testing) is a form of deliberately intense or thorough testing used to determine the stability of a given system, critical infrastructure or entity. It involves testing beyond normal operational capacity, ...
, "sensitivities" analysis *Corporate finance applications: See David Shimko (2009)
Quantifying Corporate Financial Risk
archived 2010-07-17.
cash flow analytics, corporate financing activity prediction problems, and risk analysis in capital investment * Credit scoring and
provisioning In telecommunication, provisioning involves the process of preparing and equipping a network to allow it to provide new services to its users. In National Security/Emergency Preparedness telecommunications services, ''"provisioning"'' equates to ...
; Credit scorecards and * Real options * Actuarial applications: Dynamic financial analysis (DFA), UIBFM, investment modeling These problems are generally
stochastic Stochastic (, ) refers to the property of being well described by a random probability distribution. Although stochasticity and randomness are distinct in that the former refers to a modeling approach and the latter refers to phenomena themselve ...
and continuous in nature, and models here thus require complex algorithms, entailing
computer simulation Computer simulation is the process of mathematical modelling, performed on a computer, which is designed to predict the behaviour of, or the outcome of, a real-world or physical system. The reliability of some mathematical models can be dete ...
, advanced numerical methods (such as numerical differential equations, numerical linear algebra,
dynamic programming Dynamic programming is both a mathematical optimization method and a computer programming method. The method was developed by Richard Bellman in the 1950s and has found applications in numerous fields, from aerospace engineering to economics. I ...
) and/or the development of optimization models. The general nature of these problems is discussed under , while specific techniques are listed under . For further discussion here see also: Brownian model of financial markets; Martingale pricing; Financial models with long-tailed distributions and volatility clustering; Extreme value theory; Historical simulation (finance). Modellers are generally referred to as "quants", i.e. quantitative analysts, and typically have advanced ( Ph.D. level) backgrounds in quantitative disciplines such as statistics,
physics Physics is the natural science that studies matter, its fundamental constituents, its motion and behavior through space and time, and the related entities of energy and force. "Physical science is that department of knowledge which rel ...
,
engineering Engineering is the use of scientific method, scientific principles to design and build machines, structures, and other items, including bridges, tunnels, roads, vehicles, and buildings. The discipline of engineering encompasses a broad rang ...
,
computer science Computer science is the study of computation, automation, and information. Computer science spans theoretical disciplines (such as algorithms, theory of computation, information theory, and automation) to practical disciplines (includin ...
, mathematics or
operations research Operations research ( en-GB, operational research) (U.S. Air Force Specialty Code: Operations Analysis), often shortened to the initialism OR, is a discipline that deals with the development and application of analytical methods to improve dec ...
. Alternatively, or in addition to their quantitative background, they complete a finance masters with a quantitative orientation,
Mark S. Joshi Mark Suresh Joshi (2 March 1969 – 8 October 2017) was a researcher and consultant in mathematical finance, and a professor at the University of Melbourne. His research focused on derivatives pricing and interest rate derivatives in particula ...

''On Becoming a Quant''
.
such as the
Master of Quantitative Finance A master's degree in quantitative finance concerns the application of mathematical methods to the solution of problems in financial economics. There are several like-titled degrees which may further focus on financial engineering, computational ...
, or the more specialized Master of Computational Finance or Master of Financial Engineering; the CQF certificate is increasingly common. Although spreadsheets are widely used here also (almost always requiring extensive VBA); custom C++, Fortran or Python, or numerical-analysis software such as
MATLAB MATLAB (an abbreviation of "MATrix LABoratory") is a proprietary multi-paradigm programming language and numeric computing environment developed by MathWorks. MATLAB allows matrix manipulations, plotting of functions and data, implementa ...
, are often preferred, particularly where stability or speed is a concern. MATLAB is often used at the research or prototyping stage because of its intuitive programming, graphical and debugging tools, but C++/Fortran are preferred for conceptually simple but high computational-cost applications where MATLAB is too slow; Python is increasingly used due to its simplicity, and large standard library / available applications, including
QuantLib QuantLib is an open-source software library which provides tools for software developers and practitioners interested in financial instrument valuation and related subjects. QuantLib is written in C++. History The QuantLib project was started by ...
. Additionally, for many (of the standard) derivative and portfolio applications,
commercial software Commercial software, or seldom payware, is a computer software that is produced for sale or that serves commercial purposes. Commercial software can be proprietary software or free and open-source software. Background and challenge While s ...
is available, and the choice as to whether the model is to be developed in-house, or whether existing products are to be deployed, will depend on the problem in question. See . The complexity of these models may result in incorrect pricing or hedging or both. This ''
Model risk In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activitie ...
'' is the subject of ongoing research by finance academics, and is a topic of great, and growing, interest in the risk management arena.
Criticism Criticism is the construction of a judgement about the negative qualities of someone or something. Criticism can range from impromptu comments to a written detailed response. , ''"the act of giving your opinion or judgment about the good or bad q ...
of the discipline (often preceding the
financial crisis of 2007–08 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline o ...
by several years) emphasizes the differences between the mathematical and physical sciences, and finance, and the resultant caution to be applied by modelers, and by traders and risk managers using their models. Notable here are Emanuel Derman and Paul Wilmott, authors of the '' Financial Modelers' Manifesto''. Some go further and question whether the mathematical- and statistical modeling techniques usually applied to finance are at all appropriate (see the assumptions made for options and for portfolios). In fact, these may go so far as to question the "empirical and scientific validity... of modern financial theory". Notable here are Nassim Taleb and Benoit Mandelbrot. See also , and .


Competitive modeling

Several financial modeling competitions exist, emphasizing speed and accuracy in modeling. The
Microsoft Microsoft Corporation is an American multinational corporation, multinational technology company, technology corporation producing Software, computer software, consumer electronics, personal computers, and related services headquartered at th ...
-sponsored ModelOff Financial Modeling World Championships were held annually from 2012 to 2019, with competitions throughout the year and a finals championship in New York or London. After its end in 2020, several other modeling championships have been started, including the Financial Modeling World Cup and Microsoft Excel Collegiate Challenge, also sponsored by
Microsoft Microsoft Corporation is an American multinational corporation, multinational technology company, technology corporation producing Software, computer software, consumer electronics, personal computers, and related services headquartered at th ...
.


See also

* Asset pricing model *
Economic model In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework desi ...
*
Financial engineering Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathe ...
* Financial forecast * Financial Modelers' Manifesto * Financial models with long-tailed distributions and volatility clustering *
Financial planning In general usage, a financial plan is a comprehensive evaluation of an individual's current pay and future financial state by using current known variables to predict future income, asset values and withdrawal plans. This often includes a bud ...
* Integrated business planning * Model audit * Modeling and analysis of financial markets * * *
Profit model The profit model is the linear, deterministic algebraic model used implicitly by most cost accounting, cost accountants. Starting with, profit equals sales minus costs, it provides a structure for modeling cost elements such as materials, losses, ...
* Return on modeling effort


References


Bibliography

General * * * * * * * * Corporate finance * * * * * * * * * * * * * * * * * Quantitative finance * * * * * * * * * * * * * * * * * * * * * * {{Corporate finance and investment banking Financial models Actuarial science Mathematical finance Corporate finance Computational fields of study