What is Financial Modeling
Financial modelling refers to the formal representation of financial contracts in the form of mathematical calculations or graphical representations. Financial modeling is the core of what financial engineers do. Financial engineering is all about making predictions on how a product, service, or event may be affected by changes in other factors such as time and money. In this sense, Fintalent’s financial modeling consultants also used it to predict future variables based on known present values.
Financial modeling requires a paradigm shift in the way we think about things around us. Financial modeling can be used to help you analyze the effect that different variables may have on your final outcome and/or predict what will happen in the long run based on certain parameters that are used. The best way to understand how financial modeling works is to show you how it works step-by-step. The following is a short guide on how to complete your first financial model. I would like to stress that financial modeling is different from technical analysis. Technical analysis is the process of predicting future values based on past observations whereas financial modeling works with known present values and future variables that may or may not be observed in the future.
A basic financial model consists of three parts:
1) Parameter 1: The first part of a basic financial model usually consists of one to three known variables such as time period, rate of interest, or principal amount. The start date and the end date are assumed and must be justified with some logic. This parameter defines the initial value for which we can predict our outcome.
2) Parameter 2: The second part of a financial model usually consists of a set of variables such as rate of interest, principal, time period, interest paid per month, type of asset and any other variable that is considered important to predict the outcome. Some variables will have more than one parameter such as rate of interest and time period. The use of different rates may be justified by the fact that certain events will affect the time period differently or by some logic. For example, if you want to project how your principal is going to increase over a certain period at an average annual compounded growth rate then you would then include both variables in your model. A rate can also be defined by parts. For example, if we want to express that the interest rate is 4% per year and we want to predict increases in the principal amount, we will use a four percent rate thus separating time period, principal and interest. This may be the case if your interest is paid in monthly installments and you want to predict each month’s changes in principal at an average yearly growth of four percent per year. Another example would be that your principal changes with every payment regardless of how much you pay in total. In this case, all three of these variables (amortization, interest rate, and principal amount) would need to be included in the model.
3) Parameter 3: The third part of a basic financial model consists of the answer to the following question: “What is the expected value at this point?” This is where we project our final outcome. We can calculate this value in any way that makes sense to us. Some examples of how we could express the answer are: “I am going to be paying interest at an average yearly growth rate of six percent over a period of twelve years, and my principal is growing at a four percent annual compounded growth rate. I will be paying all my interest and principal back 12 years from now.”, or “Average yearly growth rate six percent, and principal amount is going to grow by four percent over the next 12 years”.
For example, we could do the following:
1) We may buy an asset for 100 dollars or we may have some type of debt or obligation that we need to pay off at some point. We could also have a special event in our life such as getting married, having children etc.; these things change over time so it is important to always reflect that in models such as this.
2) We may also have an additional financial obligation such as a mortgage or credit card with a high interest rate. We may also have another type of financial interest such as a stock that we are invested in. Our model can be even more complex if we include all these additional variables.
In economics and finance, mathematics plays an important role in understanding patterns of economic or financial variables over time. These variables can affect our lives directly by having a large impact on our cash flow. On a more abstract and less direct level, mathematics can help us to understand the relationships between factors that are less tangible and not directly measurable. Understanding how these factors change over time can help us to better plan for our future.