Financial modeling

Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment. Many financial models are inherently stochastic.

Financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes.

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, such as metallurgy, 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, and the definitive series Handbooks in Finance by Elsevier contains several volumes dealing with financial modeling issues.

There are non-spreadsheet software platforms available on which to build financial models. However, the vast proportion of the market is spreadsheet-based, and within this market Microsoft Excel now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. From this it is easy to see how the uninformed can equate Financial modeling competency with 'learning Excel'. However, the fallacy in this contention is the one area on which professionals and experts in the financial modeling industry agree.

Selected areas of financial modeling application

• Business valuation, especially discounted cash flow
• Cost of capital or WACC
• Financial analysis
• Modeling and analysis of financial markets
• Modeling the term structure of interest rate and credit spread
• Portfolio problems
• Project finance
• Real options
• Risk modeling
• Valuation (finance)
• Option pricing

Selected books

• Ongkrutaraksa, Worapot (2006). Financial Modeling and Analysis: A Spreadsheet Technique for Financial, Investment, and Risk Management, 2nd Edition. Frenchs Forest: Pearson Education Australia. ISBN 0-733-98474-6.
• Swan, Jonathan (2008). Practical Financial Modelling, 2nd Edition. London: CIMA Publishing. ISBN 0-750-68647-2.
• Vladimirou, Hercules (2007). Financial Modeling. Norwell, MA: Springer. ISBN 0-585-13223-2.
• Jondeau, Eric (2007). Financial Modeling Under Non-Gaussian Distributions. London: Springer. ISBN 1-846-28419-9. {{cite book}}: Check |isbn= value: checksum (help); Unknown parameter |coauthors= ignored (|author= suggested) (help)
• Benninga, Simon (2006). Principles of Finance with Excel. New York: Oxford University Press. ISBN 0-195-30150-1.
• Swan, Jonathan (2005). Practical Financial Modelling. London: CIMA Publishing. ISBN 0-750-66356-1.
• Fabozzi, Frank J. (2004). Financial Modeling of the Equity Market: From CAPM to Cointegration. Hoboken, NJ: Wiley. ISBN 0-471-69900-4. {{cite book}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
• Tjia, John (2003). Building Financial Models. New York: McGraw-Hill. ISBN 0-071-40210-1.
• Benninga, Simon (1997). Financial Modeling. Cambridge, MA: MIT Press. ISBN 0-585-13223-2.

See also

• Discounted cash flow
• Enterprise value
• Financial planning
• Net present value
• Weighted average cost of capital
• Integrated business planning
• Model Audit

External links

• Eliminating Risks in Spreadsheets A useful article on how to avoid common spreadsheet modeling errors