Financial modeling is a tool designed to forecast the performance of a business, project, or any other form of financial investment. A financial model uses relationships among macro-economic, operating, investing, tax, accounting, and financing variables to predict performance. The central aim of financial modeling is to forecast uncertainty and mitigate risk.
The discussion about risk mitigation peaks up at times of crisis and recedes along with it. The series of financial crisises such as US saving and loan collapse in the 1980s, black Monday in 1987, dot-com bust of 2000 and now the sub-prime crisis have left a strong message that risk is always there with us. Unfortunately, people at large have rendered mathematical modeling incomprehensible and a something outside the finance function. Corporates have started to shied away from the powerful risk management tools that has been created over the past three decades and are losing oppertunities to make money.
There is considerable debate amongst experts in the industry as to the nature of financial modeling is a tradecraft, such as welding, or a science, such as rmeta physics or an art like sketching. There is also a bigger debate as to whether use these complex finanacial model, whose wrong applications has lead to huge losses and turmoil.
The discussion about risk mitigation peaks up at times of crisis and recedes along with it. The series of financial crisises such as US saving and loan collapse in the 1980s, black Monday in 1987, dot-com bust of 2000 and now the sub-prime crisis have left a strong message that risk is always there with us. Unfortunately, people at large have rendered mathematical modeling incomprehensible and a something outside the finance function. Corporates have started to shied away from the powerful risk management tools that has been created over the past three decades and are losing oppertunities to make money.
There is considerable debate amongst experts in the industry as to the nature of financial modeling is a tradecraft, such as welding, or a science, such as rmeta physics or an art like sketching. There is also a bigger debate as to whether use these complex finanacial model, whose wrong applications has lead to huge losses and turmoil.
In order to see the positives of modeling, one needs to understand as to how these tools evolved and put to use. Initially only way of risk mitigation was to buy an insurance. After some time, some futures and options were sold in order to transfer the element risk. There was a break through when Fischer Black and Myron Scholes propounded the famous Black-Scholes model for option pricing. This model was more effective in mitigation of risk.
Many organizations (read hedge funds and investment bankers) turned adventurous and build models which where primarily aimed at making profits rather than mitigating & transferring risk to others. Banks tried to pack every poor asset into a structured investment vehicle and sell it to others. As a result the total financial assets in the world soared from $ 12 trillion in 1980 to $195 trillion in 2007. In fact the financial assets grew at a faster pace than the world economy in this period.
These fancy models built by participants, produced great results and the builders of models where admired. These models provided wider access to capital, increased opportunities for sharing risk and in turn spurred economic activity. All models which were intended to make a windfall produced great results in short run and lead to a bubble. As these bubbles started to burst there was market turmoil, leading to devastating recessions. And everyone was cursing these models for the devastation.
People who build these fancy models failed to realize the primary purpose of these models, which was to mitigate risk effectively and not make a windfall out of it. As policy makers and the corporate world look ahead, the goal should be to enable the world to enjoy the benefits of risk mitigation and sharing of risk more effectively. But success depends on updating our thinking, not shielding away.
These fancy models built by participants, produced great results and the builders of models where admired. These models provided wider access to capital, increased opportunities for sharing risk and in turn spurred economic activity. All models which were intended to make a windfall produced great results in short run and lead to a bubble. As these bubbles started to burst there was market turmoil, leading to devastating recessions. And everyone was cursing these models for the devastation.
People who build these fancy models failed to realize the primary purpose of these models, which was to mitigate risk effectively and not make a windfall out of it. As policy makers and the corporate world look ahead, the goal should be to enable the world to enjoy the benefits of risk mitigation and sharing of risk more effectively. But success depends on updating our thinking, not shielding away.
0 comments:
Post a Comment