On Financial Modeling and Risk Analysis

Here are some basic questions that I am frequently asked about financial modeling and risk analysis:

What is financial modeling...?

The process by which a firm constructs a financial representation of some, or all, aspects of the firm or a 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.

What does financial modeling entail...?

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.

What is risk analysis...?

The study of the underlying uncertainty of a given course of action. Risk analysis refers to the uncertainty of forecasted future cash flows streams, variance of portfolio/stock returns, statistical analysis to determine the probability of a project's success or failure, and possible future economic states. Risk analysts often work in tandem with forecasting professionals to minimize future negative unforseen effects.

What does risk analysis entail...?

Almost all large businesses require a minimum sort of risk analysis. For example, commercial banks need to properly hedge foreign exchange exposure of oversees loans while large department stores must factor in the possibility of reduced revenues due to a global recession. Risk analysis allows professionals to identify and mitigate risks, but not avoid them completely. Proper risk analysis often includes mathematical and statistical software programs.

Source: Investopedia