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Encyclopedia of Financial Models III by Frank J. Fabozzi

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Preface

It is often said that investment management is an art, not a science. However, since the early 1990s the market has witnessed a progressive shift toward a more industrial view of the investment management process. There are several reasons for this change. First, with globalization the universe of investable assets has grown many times over. Asset managers might have to choose from among several thousand possible investments from around the globe. Second, institutional investors, often together with their consultants, have encouraged asset management firms to adopt an increasingly structured process with documented steps and measurable results. Pressure from regulators and the media is another factor. Finally, the sheer size of the markets makes it imperative to adopt safe and repeatable methodologies.

In its modern sense, financial modeling is the design (or engineering) of financial instruments and portfolios of financial instruments that result in predetermined cash flows contingent upon different events. Broadly speaking, financial models are employed to manage investment portfolios and risk. The objective is the transfer of risk from one entity to another via appropriate financial arrangements. Though the aggregate risk is a quantity that cannot be altered, risk can be transferred if there is a willing counterparty.

Financial modeling came to the forefront of finance in the 1980s, with the broad diffusion of derivative instruments. However, the concept and practice ...

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