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Advance
Topics in
Financial
Modeling
Lecture 2
Kaushank Khandwala

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Plan for this lecture

Applications of Financial Modeling

Revisit Trend and Overlay Chart Applications
Crystal Balls basic probability distributions
Defining decision variables

Financial Modeling
Applications
In Corporate finance, investment banking and PE profession ,financial modeling is
concerned with cash-flow projection and forecasting

Business valuation, (discounted cash flow, price multiples)

Scenario planning and management decision making
Capital budgeting, Cost of capital (i.e. WACC) calculations
Project Finance, Financial statement analysis

Financial Modeling
Applications
In quantitative finance, financial modeling entails development of a sophisticated math model
dealing with asset prices, market movements, portfolio returns.
Applications include:
Option pricing and calculation of "Greeks"
Structuring Other derivatives, especially Interest rate derivatives and Exotic derivatives
Corporate financing activity prediction problems
Real options
Risk modeling and Value at risk.

Charts Revisited

Charts help us visualize, understand, and communicate the simulation results.

Overlay and Trend charts can help comparison of results from multiple forecast charts
simultaneously.

A trend chart summarizes and displays information from multiple forecasts, making it easy to
discover and analyze trends that might exist between related forecasts. You can customize
your trend chart to display the probability that given forecasts will fall in a particular range.

Overlay chart feature to view the relative characteristics of forecasts on one chart. The
overlay chart superimposes the frequency data from selected forecasts so you can compare
differences or similarities that otherwise might not be apparent. There is no limit to the
number of forecasts you can overlay

Trend Chart

Trend chart comparing accumulated values after 30 years of retirement savings for nine
different allocations into stocks and bonds each year.

Overlay Chart

Overlay chart comparing accumulated value after 30 years of retirement

savings for two different allocations into stocks and bonds each year.
The 9010 portfolio almost completely dominates the 5050 portfolio in
the sense that the line representing the 9010 portfolio is above and to
the right of the 5050 line almost everywhere.

Overlay Chart

For Year 30 Wealth values below about $1 million, the lines are virtually
indistinguishable.
While very risk-averse investors might prefer the 5050 portfolio because it
dominates the 9010 portfolio slightly in the worst 10 percent of the cases,
most investors would prefer the 9010 portfolios wealth distribution because
of its near equivalence in the lowest 10 percent and dominance in the upper
90 percent of the potential returns.

Type of Distributions

Basic distributions listed in Crystal Balls distribution gallery.

Bernoulli Yes-No Distribution

The random variable Y has the Bernoulli distribution if it can take only one of two
possible values, y = 0 or y = 1. The value y = 1 is called a success, and y = 0 is
called a failure in probability parlance.
In Crystal Ball, the Bernoulli distribution is known as the yes-no distribution.

Binomial Distribution

Binomial(p,n) is the distribution of the sum of a fixed number, n, of Bernoulli

trials that all have the same probability of success, p.
The problem of determining the distribution of the number of heads in five
tosses of a fair coin can be solved by using one Crystal Ball assumptionthe
binomial(0.5,5)

Discrete Uniform Distribution

Discrete uniform(L,H) distribution assigns equal probability to the set of

integers between L and H, inclusive.
For L = 1 and H = 6, it is the probability distribution representing the number of
spots showing on the top face of a fair die rolled randomly

Uniform Distribution

Uniform distribution has only two parameters, the minimum and

maximum values.
It produces any continuous value between the minimum and maximum
with equal likelihood

Triangular Distribution

Triangular distribution is appropriate for use when you have little or no data
available, but you know the minimum, maximum, and most likely values of a
random variable.
The triangular distribution is completely specified by its three parameters,
Minimum, Likeliest, and Maximum. These three values are sufficient to
determine the triangular shape shown in the icon.

Normal Distribution

Normal distribution is describes many natural phenomena. The normal distribution is

specified by its two parameters, the Mean and Std Dev (standard deviation).
Because it is symmetrical, the mean is equal to the median (50th percentile).
The mode (point on the horizontal axis at which the PDF is highest) is also equal to
the mean and median.
Values simulated from the normal distribution are more likely to be close to the mean
than far away.

Lognormal Distribution

Lognormal distribution takes its name from the fact that it represents a random variable
whose natural logarithm follows the normal distribution.
The lognormal distribution is bounded on the left by zero; however, it is unbounded on the
right just as the normal distribution.
This makes it useful for situations where values are positively skewed and cannot be
negative, such as the total return on stock when the stockholders potential loss is
limited to the amount he or she has invested, or for sales of a product, which cannot
be negative.

HISTORICAL DATA TO CHOOSE

DISTRIBUTIONS
If you have historical data on an input variable, there are two different methods for
using them in a Crystal Ball model:
(1) direct sampling, and
(2) sampling from a fitted distribution.

HISTORICAL DATA TO CHOOSE

DISTRIBUTIONS
Direct simulation can only reproduce what has already happened, and the
number of trials usually exceeds the number of data values available, so that you
will be using the same values many times over.
Using direct sampling can lead to a false sense of precision and is not generally
recommended.
Sampling from a Fitted Distribution involves standard techniques of statistical
inference to fit a theoretical distribution to your data using one of the distribution
gallerys continuous distributions.
The fitting and selection is nearly automatic, although it does require some
judgment and subject matter knowledge to use most effectively.

What If No Historical Data

Are Available?
Financial models are often built to analyse situations that do not yet exist; for
example, new products or projects in which the company has little or no historical
data to help choose assumptions.
In this case, you will have to make your own subjective estimates of which
assumptions to use in the model, or solicit the help of a SME.
Building a model without historical data can provide many valuable insights.
However, as soon as possible, you should collect data on the stochastic variables
driving your forecasts and parameterize the assumptions.
Among other reasons, this will also allow you to estimate any correlations
between the assumptions, which can make a huge difference in the forecast
results.
Common techniques used are : Specifying the Spearman/Pearson estimators,
Batch Fitting .