Financial Modeling - A Part of Equity research

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

 Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment. Many financial models are inherently stochastic.

Financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes.

While there has been some debate in the industry as to the nature of financial modeling : whether it is a tradecraft, such as welding, or a science, such as metallurgy, the task of financial modeling has been gaining acceptance and rigor over the years. Several scholarly books have been written on the topic, in addition to numerous scientific articles, and the definitive series Handbooks in Finance by Elsevier contains several volumes dealing with financial modeling issues.

There are non-spreadsheet software platforms available on which to build financial models. However, the vast proportion of the market is spreadsheet-based, and within this market Microsoft Excel now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. From this it is easy to see how the uninformed can equate Financial modeling competency with 'learning Excel'. However, the fallacy in this contention is the one area on which professionals and experts in the financial modeling industry agree.

The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives. Financial models can be constructed in many ways, either by the use of computer software, or with a pen and paper. What's most important, however, is not the kind of user interface used, but the underlying logic that encompasses the model. A model, for example, can summarize investment management returns, such as the Sortino ratio, or it may help estimate market direction, such as the Fed model.

Fed Model: A model thought to be used by the Federal Reserve that hypothesizes a relationship between long-term treasury notes and the market return of equities. The Fed doesn't endorse this tool. In fact, it was named the"Fed model" by Prudential Securities strategist Ed Yardeni.
This model believes that returns on 10-year treasury notes should be similar to the S&P 500 earnings yield. Differences in these returns identify an over-priced or under-priced securities market.

Black Scholes Model: A model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes that the price of heavily traded assets follow a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price and the time to the option's expiry.
Also known as the Black-Scholes-Merton Model. The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options.
There are a number of variants of the original Black-Scholes model.

Black Box Model: A computer program into which users enter information and the system utilizes pre-programmed logic to return output to the user. The "black box" portion of the system contains formulas and calculations that the user does not see nor need to know to use the system. Black box systems are often used to determine optimal trading practices. These systems generate many different types of data including buy and sell signals.

Black's Model: A variation of the Black-Scholes model that allows for the valuation of options on futures contracts. In 1976, Fisher Black, one of the developers of the Black-Scholes model (introduced in 1973), demonstrated how the Black-Scholes model could be modified in order to value European call or put options on futures contracts.

Heath-Jarrow-Morton Model - HJM Model: A model that applies forward rates to an existing term structure of interest rates to determine appropriate prices for securities that are sensitive to changes in interest rates. The HJM model is very theoretical and is used at the most advanced levels of financial analysis. It is used mainly by arbitrageurs seeking arbitrage opportunities.

Lintner's Model: A model stating that dividend policy has two parameters: (1) the target payout ratio and (2) the speed at which current dividends adjust to the target. In 1956 John Lintner developed this theory based on two important things that he observed about dividend policy:

1) Companies tend to set long-run target dividends-to-earnings ratios according to the amount of positive net-present-value (NPV) projects they have available.

2) Earnings increases are not always sustainable. As a result, dividend policy is not changed until managers can see that new earnings levels are sustainable.