Financial modeling

Date: 2015-10-07; view: 469.

Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation. This is a mathematical model designed to represent the performance of a financial asset or a portfolio, of a business, a 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 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. Several scholarly books have been written on the topic, in addition to numerous scientific articles.

In corporate finance, investment banking and the accounting profession financial modeling is synonymous with cash flow forecasting. This usually involves the preparation of large, detailed company specific models used for decision making purposes. Applications include:

Business valuation, especially discounted cash flow, but including other valuation problems;

Scenario planning and management decision making «what is»; «what if»; «what has to be done»;

Capital budgeting;

Cost of capital calculations;

Financial analysis and / or Financial statement analysis;

Project finance.

These models are generally built around financial statements, and therefore outputs, and calculations, are typically monthly or quarterly. This means that accounting based financial models are mathematically (at least implicitly) in discrete time. Model inputs often 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.) and internal / company specific variables (wages, unit costs, etc.). Given that these input values are specified, the models are mathematically (implicitly) deterministic.

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. Applications include:

· Option pricing;

· Modeling the term structure of interest rates (short rate modeling) and credit spreads;

· credit scoring and provisioning;

· Portfolio problems;

· Real options;

· Risk modeling.

These problems are often stochastic and continuous in nature, and models here thus require complex algorithms, entailing computer simulation, advanced numerical methods such as numerical differential equations, and / or the development of optimization models.

Modelers are generally referred to as «quants» (quantitative analysts), and typically have strong (Ph.D. level) backgrounds in quantitative disciplines such as physics, computer science, mathematics or engineering. Alternatively, they have completed a finance masters with a quantitative orientation – such as the Master of Quantitative Finance or Master of Finance – or the more specialized Master of Computational Finance or Master of Financial Engineering.

Although spreadsheets (e.g. Microsoft Excel) are widely used here, custom C++ or numerical analysis software such as MATLAB is often preferred, particularly where stability or speed is a concern. Additionally, for many derivative and portfolio applications, commercial software 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.

Criticism of financial modeling emphasizes the differences between the mathematical and physical sciences and finance. Some experts go further and question whether mathematical and statistical modeling may be applied to finance at all, at least with the assumptions usually made (for options, portfolios, etc.).

Task 1. Fill in the table with the words and phrases from the text and give their Russian equivalents: