n corporate finance and the accounting profession, financial modeling typically entails financial

statement forecasting; usually the preparation of detailed company-specific models used for
decision making purposes[1] and financial analysis.

Applications include:

Business valuation, especially discounted cash flow, but including other valuation approaches

Scenario planning and management decision making ("what is"; "what if"; "what has to be
done"[4])

Capital budgeting

Cost of capital (i.e. WACC) calculations

Financial statement analysis (including of operating- and finance leases, and R&D)

Project finance

Cash flow forecasting and asset and liability management related

To generalize[citation needed] as to the nature of these models: firstly, as they are built around
financial statements, calculations and outputs are monthly, quarterly or annual; secondly, the
inputs 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.…; may be
thought of as the model parameters), and for internal / company specific variables (wages, unit
costs, etc.…). Correspondingly, both characteristics are reflected (at least implicitly) in the
mathematical form of these models: firstly, the models are in discrete time; secondly, they are
deterministic. For discussion of the issues that may arise, see below; for discussion as to more
sophisticated approaches sometimes employed, see Corporate finance #Quantifying
uncertainty, and Financial economics #Corporate finance theory.

Modelers are often designated "financial analyst" (and are sometimes referred to (tongue in
cheek) as "number crunchers") . Typically, the modeler will have completed an MBA or MSF with
(optional) coursework in "financial modeling". Accounting qualifications and finance
certifications such as the CIIA and CFA generally do not provide direct or explicit training in
modeling.[citation needed] At the same time, numerous commercial training courses are
offered, both through universities and privately.
Although purpose built business software does exist (see also Fundamental Analysis Software),
the vast proportion of the market is spreadsheet-based; this is largely since the models are
almost always company specific. Also, analysts will each have their own criteria and methods for
financial modeling.[5] (For the components / steps of business modeling here, see the list for
"Equity valuation" under Outline of finance #Discounted cash flow valuation.) Microsoft Excel
now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. Spreadsheet-
based modelling can have its own problems,[6] and several standardizations and "best
practices" have been proposed.[7] "Spreadsheet risk" is increasingly studied and managed;[7]
see model audit.

One critique here, is that model outputs, i.e. line items, often incorporate "unrealistic implicit
assumptions" and "internal inconsistencies".[8] (For example, a forecast for growth in revenue
but without corresponding increases in working capital, fixed assets and the associated
financing, may imbed unrealistic assumptions about asset turnover, leverage and / or equity
financing.) What is required, but often lacking, is that all key elements are explicitly and
consistently forecasted. Related to this, is that modellers often additionally "fail to identify
crucial assumptions" relating to inputs, "and to explore what can go wrong".[9] Here, in general,
modellers "use point values and simple arithmetic instead of probability distributions and
statistical measures"[10] — i.e., as mentioned, the problems are treated as deterministic in
nature — and thus calculate a single value for the asset or project, but without providing
information on the range, variance and sensitivity of outcomes.[11] Other critiques discuss the
lack of basic computer programming concepts.[12] More serious criticism, in fact, relates to the
nature of budgeting itself, and its impact on the organization.[13][14]

The Financial Modeling World Championships, known as ModelOff, have been held since 2012.
ModelOff is a global online financial modeling competition which culminates in a Live Finals
Event for top competitors. From 2012-2014 the Live Finals were held in New York City and in
2015, in London.[15]

Quantitative finance

In quantitative finance, financial modeling entails the development of a sophisticated

mathematical model.[citation needed] Models here deal with asset prices, market movements,
portfolio returns and the like. A general distinction[citation needed] is between: "quantitative
financial management", models of the financial situation of a large, complex firm; "quantitative
asset pricing", models of the returns of different stocks; "financial engineering", models of the
price or returns of derivative securities; "quantitative corporate finance", models of the firm's
financial decisions.
Relatedly, applications include:

Option pricing and calculation of their "Greeks"

Other derivatives, especially interest rate derivatives, credit derivatives and exotic derivatives

Modeling the term structure of interest rates (Bootstrapping, short rate modelling, building
"curve sets") and credit spreads

Credit scoring and provisioning

Corporate financing activity prediction problems

Portfolio optimization.[16]

Real options

Risk modeling (Financial risk modeling) and value at risk[17]

Dynamic financial analysis (DFA)

Credit valuation adjustment, CVA, as well as the various XVA

These problems are generally stochastic and continuous in nature, and models here thus require
complex algorithms, entailing computer simulation, advanced numerical methods (such as
numerical differential equations, numerical linear algebra, dynamic programming) and/or the
development of optimization models. The general nature of these problems is discussed under
Mathematical finance, while specific techniques are listed under Outline of finance#
Mathematical tools. For further discussion here see also: Financial models with long-tailed
distributions and volatility clustering; Brownian model of financial markets; Martingale pricing;
Extreme value theory; Historical simulation (finance).

Modellers are generally referred to as "quants" (quantitative analysts), and typically have
advanced (Ph.D. level) backgrounds in quantitative disciplines such as statistics, physics,
engineering, computer science, mathematics or operations research. Alternatively, or in
addition to their quantitative background, they complete a finance masters with a quantitative
orientation,[18] such as the Master of Quantitative Finance, or the more specialized Master of
Computational Finance or Master of Financial Engineering; the CQF is increasingly common.
Although spreadsheets are widely used here also (almost always requiring extensive VBA),
custom C++, Fortran or Python, or numerical analysis software such as MATLAB, are often
preferred,[18] particularly where stability or speed is a concern. MATLAB is often used at the
research or prototyping stage[citation needed] because of its intuitive programming, graphical
and debugging tools, but C++/Fortran are preferred for conceptually simple but high
computational-cost applications where MATLAB is too slow; Python is increasingly used due to
its simplicity and large standard library. Additionally, for many (of the standard) 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.[18]

The complexity of these models may result in incorrect pricing or hedging or both. This Model
risk is the subject of ongoing research by finance academics, and is a topic of great, and growing,
interest in the risk management arena.[19]

Criticism of the discipline (often preceding the financial crisis of 2007–08 by several years)
emphasizes the differences between the mathematical and physical sciences, and finance, and
the resultant caution to be applied by modelers, and by traders and risk managers using their
models. Notable here are Emanuel Derman and Paul Wilmott, authors of the Financial Modelers'
Manifesto. Some 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; for
portfolios). In fact, these may go so far as to question the "empirical and scientific validity... of
modern financial theory".[20] Notable here are Nassim Taleb and Benoit Mandelbrot.[21] See
also Mathematical finance #Criticism and Financial economics #Challenges and criticism.