financial modeling

(noun)

the task of building an abstract representation (a model) of a financial decision making situation.

Related Terms

Examples of financial modeling in the following topics:

  • Strategic Planning

    • Financial forecasting is often helped by processes of 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 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.Typically, financial modelling is understood to mean an exercise in either asset pricing or corporate finance, of a quantitative nature.
    • In other words, financial modelling is about translating a set of hypotheses about the behavior of markets or agents into numerical predictions; for example, a firm's decisions about investments or investment returns.

  • Leverage Models

    • Models that allow us to interpret appropriate financial leverage include the Modigliani-Miller theorem and the Degree of Financial Leverage.
    • There are several measures we can use to define and quantify the effect of financial leverage.
    • Financial leverage can be measured, or defined, using certain ratios.
    • The higher the Degree of Financial Leverage, the riskier the business.
    • Financial leverage is defined as the ratio of operating income to net income.

  • The Capital Asset Pricing Model

    • The capital asset pricing model (CAPM) allows us to price risky securities in order to determine if an investment should be undertaken.
    • The capital asset pricing model is a financial model, used to price risky securities, that describes the relationship between risk and expected return.
    • The model takes into account the asset's sensitivity to market fluctuations, often represented by the quantity beta (β), as well as the expected return of the market and the expected return of a theoretical risk-free asset .
    • Further, the model assumes that past returns will effectively predict the future risk associated with a given security.
    • Calculate a company's expected rate of return using the Capital Asset Pricing Model (CAPM)

  • Inputs

    • In corporate finance, investment banking, and the accounting profession, financial modeling is largely synonymous with cash flow forecasting.
    • This usually involves the preparation of detailed company specific models used for decision making purposes and financial analysis.
    • A financial forecast is an estimate of future financial outcomes for a company or country (for futures and currency markets).
    • Unlike a financial plan or a budget, a financial forecast doesn't have to be used as a planning document.
    • Time series forecasting is the use of a model to predict future values based on previously observed values.

  • Types of Risk

    • There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.
    • The term "financial risk" is broad, but can be broken different categories to understand it better.
    • Model risk involves the chances that past models, which have been used to diversify away risk, will not accurately predict future models.
    • Classify different securities by the types of financial risk associated with the investment opportunity

  • Behavior of an Efficient Market

    • Efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should therefore move unpredictably.
    • Critics have blamed the belief in rational markets for much of the late-2000's financial crisis.
    • Historically, there was a very close link between EMH and the random-walk model and then the Martingale model.
    • A small number of studies indicated that U.S. stock prices and related financial series followed a random walk model.
    • The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

  • The DuPont Equation

    • Financial Leverage = 5,000,000/10,000,000 = 50%.
    • This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.
    • Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage.
    • As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity.
    • In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.

  • Maximizing Shareholder and Market Value

    • Financial management is concerned with financial matters for the practical significance of the numbers, asking: what do the figures mean?
    • There are several goals of financial management, one of which is maximizing shareholder and market value .
    • There are many different models of corporate governance around the world.
    • The Anglo-American (US and UK) "model" tends to emphasize the interests of shareholders.
    • Maximizing shareholder and market value is, for some, one of the goals of financial management.

  • Relationship Between Financial Policy and the Cost of Capital

    • Financial policy, not cost of capital, must be utilized to determine which investments to pursue, given that resources are limited.
    • Financial policy is used by companies or investors in order to determine the best way to allocate their resources.
    • To analyze various options, managers use valuation techniques, such as the capital asset pricing model or discounted cash flow analysis.
    • The use of financial policy in decision making does not only involve valuation.
    • Explain the relationship between a company's financial policy and its cost of capital

  • Implications and Limitations of the Efficient Market Hypothesis

    • One could also argue that if the hypothesis is so weak, it should not be used in statistical models due to its lack of predictive behavior.
    • Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case.
    • The financial crisis of 2007–2012 has led to renewed scrutiny and criticism of the hypothesis.
    • Market strategist Jeremy Grantham has stated flatly that the EMH is responsible for the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking. " Noted financial journalist Roger Lowenstein blasted the theory, declaring "the upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the Efficient-Market Hypothesis. " Former Federal Reserve chairman Paul Volcker chimed in, saying, "[it is] clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations and market efficiencies. "
    • Critics have suggested that financial institutions and corporations have been able to decrease the efficiency of financial markets by creating private information and reducing the accuracy of conventional disclosures, and by developing new and complex products which are challenging for most market participants to evaluate and correctly price.