Financial modeling involves building an abstract representation of a financial decision-making situation. This is a mathematical model designed to represent the performance of a financial asset or portfolio of a business, project, or any other investment.2 Financial modeling also characterizes the financial operations or financial statements of a company in terms of its business parameters and forecasts future financial performance. Models are used for risk management by examining different economic scenarios for the future. Financial models are also used to provide valuations of individual assets that might not be actively traded in a secondary market.3
One of the most important tasks in finance is to find good mathematical models for financial products, in particular derivatives. However, the more realistic the model, the more practitioners face complex problems in mathematics and econometrics.
Modeling derivatives is of particular importance due to the relative size of the derivative market when compared to the real economy.
If we examine the Bank of International Settlements (BIS) estimate of “Amounts outstanding of over-the-counter (OTC) derivatives” in December 2010, this amounted to US$601, 046 billion. To the World Bank estimate of World Gross Domestic Product (GDP) for 2010,4 the volume of financial transactions in the global economy is 73.5 times higher than nominal world GDP.
In 1990, this ratio amounted to “only” 15.3. Transactions of stocks, bonds, and foreign exchange have expanded roughly in tandem with nominal world GDP. Hence, the overall increase in financial trading is exclusively due to the spectacular boom of the derivatives markets.
In the final analysis, the mathematical modeling of this system of obligations is an imperative for the world economy’s well-being.
2Kaplan Singapore, “Financial Modeling in Excel,” http://www.kaplan.com.sg/kli/page-course/financial-modeling-in-excel-10085-935/.
3Nasdaq, “Financial model,” http://www.nasdaq.com/investing/glossary/f/financial-model.
4Bill Mitchell’s blog, “What is Wall Street for?” http://bilbo.economicoutlook.net/blog/?p=16357.