In this chapter, we discuss the meaning and purpose of financial modelling, and provide some simple introductory examples. We also summarise the skill sets that a well-rounded and professional financial modeller should possess, which also provides the context for the structure and content of the overall CertFM Program.
A model is a representation (or portrayal) of a real-life situation or system. It describes the key elements within the system, and the relationships between them. To do this, it could use various means (qualitative or quantitative or both), discussed briefly below.
Art, sculpture and objects made with Lego® may be considered as models: They express key elements and their relationships between the items in a system.
Decision trees and influence (or flow) diagrams are examples of models in which the logic, dependency relationships, choices, and possible outcomes within a situation are expressed within a specific type of fairly standardised (visual framework).
A full-text description of a situation can also be considered as a model, so long as it provides a clear description of the elements within the situation and their relationships, and does do in a way which is precise and unambiguous; in particular, if the description were sufficient to be able to create a set of calculations (for example in Excel), then it can be considered as a form of model.
This is where mathematics is used to define all elements precisely, and the relationships are expressed using formulas. There need be no numerical implementation or calculations, and the process to create these maybe regarded as implementation, but not modelling in a strict sense.
The relationships and behaviour of a system could be captured directly within a set of calculations (very often using Excel). The relationships are specified implicitly through the calculations, and there is no external reference (apart from general knowledge), unless separate explicit documentation (such as a full-text description) is provided.
As a representation of some situation, a model is inherently incomplete: There are almost always features or behaviours of the real-life situation that cannot be captured exactly. However, the aim is to capture the key elements in a way that is sufficient to fulfil a particular purpose.
It is sometimes stated that “every model is wrong, some are useful” and that “every model should be as simple as possible, but no simpler”. These are important reflections to bear in mind, both for the simplest and most complex situations.
Modelling is used in many fields, with including:
A “financial model” is simply one for which the real-life situation is in economics, business or finance. Financial models may also use large data sets or databases as part of their inputs, and so there is a close link with general data analysis (a link which is discussed in detail in later materials).
Excel is the most widespread tool used to build financial models (by direct numerical implementation, coupled with background knowledge and appropriate documentation). The CertFM Program therefore covers a wide set of modelling-related functionality and functions in Excel, as well as its ever-increasing tools to manipulate and analyse data sets.
However, to master financial modelling (in Excel), one needs knowledge that goes far beyond the direct use of Excel. Notably, a good knowledge of economic theory, finance, decision analysis, and statistical methods (amongst others) are all required: These are all topics which are separate to Excel in concept, even as using Excel can help to create a better understanding of them, and to implement many aspects in practice.
Thus, Excel is the focus of the methods used within the CertFM Program, even as many other topics and concepts are also covered.