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Encyclopedia of Financial Models II by Frank J. Fabozzi

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From Art to Financial Modeling

SERGIO M. FOCARDI, PhD

Partner, The Intertek Group

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: 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. The S&P 500 index is itself chosen from a pool of 8,000 investable U.S. stocks. Second, institutional investors, often together with their investment 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. Lastly, the sheer size of the markets makes it imperative to adopt safe and repeatable methodologies. The volumes are staggering.

In its modern sense, financial modeling is the design (or engineering) of contracts and portfolios of contracts that result in predetermined cash flows contingent on 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 contracts. Though the aggregate risk is a ...

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