3/21/2022

Model Development
• Models are representations of real objects or situations
 Mathematical models - represent real world problems through a system of

Introduction to Financial mathematical formulas and expressions based on key assumptions, estimates, or
statistical analyses
Generally, experimenting with models (compared to experimenting with the real

Modelling situation):
• requires less time
• is less expensive
• involves less risk
Cost/benefit considerations must be made in selecting an appropriate
mathematical model.
Frequently a less complicated (and perhaps less precise) model is more appropriate
than a more complex and accurate one due to cost and ease of solution
considerations.

What is a Financial Model? Input-Process-Output (IPO) Cycle

• A financial model is designed to represent or capture in mathematical
terms the relationship among the variables of a financial problem so
that it can answer “what-if” questions or make projections…
• Use of spreadsheets…
• Want to capture the interdependencies between the variables
• Structure should be so as to be able to answer “what-if” questions, i.e.
change the values of the independent variables and see the effect on the
dependent variable
• Systematic approach - planning…
A problem can be broken down into four components:
1. Input - any data that is needed to solve the problem
2. Processing - the task that will be carried out to solve the problem
3. Output - the end result of the problem
4. Storage - variables are used to store data/values to perform calculation
The IPO (Input, Processing & Output) chart can be used to analyze a
problem. This is a table with three columns, which represent three
components: input, output and processing.
Input Processing Output
 3/21/2022

Steps to complete an IPO Chart: Mathematical Models

1. Identify the inputs (what is needed from the user of the model).
2. Write the outputs (the end results that are required in the problem).
3. In the processing column write "get" and anything that is under the
input column. If nothing is under the input column, leave out this step.
4. Ask yourself the following question. “What do I have to do with the
inputs in order to produce the desired output?” Then write down what
should be done.
5. Write "display" and anything under the Output column.
• Relate decision variables (controllable inputs) with fixed
parameters or random inputs (uncontrollable inputs).
• Generally: seek to maximize or minimize some objective
function subject to constraints.
• Stochastic if any of the uncontrollable inputs is subject to
variation; deterministic if all inputs are fixed.
• Generally, stochastic models are more difficult to analyze.
• The values of the decision variables that provide the
mathematically-best output are referred to as the optimal
solution for the model.

Steps in constructing a financial model Example: tax computation

1. Define and Structure the Problem • Given tax brackets & tax rates
a. Discuss and Define why the Model is needed and what decisions will be made
based on the output… • Naïve approach: use spreadsheet as a calculator, manually look up rates…
b. Establish how accurate or realistic the Model needs to be - to what extent should • Modelling approach: use nested IF or VLOOKUP functions…
the Model capture the interdependencies between the variables
2. Define the Input and Output Variables for the Model.
a. Make a list of all Inputs and where they will be obtained from
b. Make a list of the tabular, graphical, and other outputs required
3. Decide who will use the Model and how often
4. Understand the Financial and Mathematical aspects of the Model
5. Design the Model
6. Create the Spreadsheets/Codes
7. Test the Model
8. Protect the Model
9. Document the Model
10. Update the Model as Necessary