Financial Modeling

Short Title: FM

Semester - III 3 CREDITS

July - October COURSE INSTRUCTOR

2018 Dr. Chetan G K

Course Objective:

This course involves students to develop a financial model using Microsoft Excel for representing a
company’s past, present, and future business operations. Modelling takes the student through
assumptions on the historical data, projection of financial statements and selecting appropriate
projection drivers for predicting the future business operations.

Learning outcomes:

By the end of this course, students should be able to:

1. Evaluate various financial values used in valuation of firms
2. Build WACC in MS-Excel
3. Build pro-forma models
4. Build efficient frontier and efficient portfolio in MS-Excel
5. Understand and calculate beta and SML
6. Adapt Black-Scholes formula in valuation of structured assets
7. Interpret the meaning and application of Option Greeks
8. Assess impact of different real options
9. Estimate bond duration and model term structures using spreadsheet
10. Simulate stock prices using Monte Carlo methods

Pedagogy:

 The course will be taught through a mix of numeric problems and lectures.
 MS – Excel spreadsheets are used to solve the problems. Wherever necessary, the concepts of the
problem will be explained.

Prerequisites:

3FME07 is an elective course in Finance function. Please note that students should have prior
knowledge of Corporate Finance, Corporate Valuation, Security Analysis and Portfolio Management,
and Financial Derivatives before attending the Financial Modeling course. It is advised that the students
should brush up all these concepts before attending the Financial Modeling sessions. It is assumed that
students have enough working knowledge and are equipped with accounting, economics and statistics
subjects that have been part of their previous semesters.
Course Contents:

Module 1:
Corporate Finance and Valuation models
Basic financial calculations – NPV, IRR, payment schedules and loan tables, future value, pension and
accumulation problems, continuously compounded interest; overview of corporate valuation, calculating
weighted average cost of capital (WACC), valuation based on consolidated statement of cash flows,
Building a pro-forma model and overview of financial analysis

Module 2:
Portfolio Models
Introduction to portfolio models, calculating efficient portfolios – how to calculate efficient portfolios
and how to calculate efficient frontier, calculating variance-covariance matrix, estimating betas and
security market line – calculate beta for set of assets, determine equation of security market line (SML),
Efficient portfolios without short sales, The Black-Litterman approach to portfolio optimization.

Module 3:
Valuation of options
Introduction to options – basic option definitions, terminology and payoffs, the binomial option pricing
model, the Black-Scholes model – mechanics of the model, uses of Black-Scholes formula in valuation
of structured assets, option Greeks- Delta, Gamma, Vega, Theta, Rho, and real options – option to defer,
time-to-build (staged investment) option, option to alter operating scale, option to abandon, option to
switch outputs and inputs, the growth option.

Module 4 :
Valuing bonds
Introduction to bonds, bond duration – measurement of sensitivity of a price of a bond to changes in
the interest rate- Macaulay duration, immunization strategies – simplest duration concept of Macaulay,
modelling the term structure – simplest term structure with one bond for each period, Nelson-Siegel
model, variation of NS model due to Svensson, calculating default-adjusted expected bond returns –
Markov models

Module 5:
Monte Carlo Methods
Generating and using random numbers, introduction to Monte Carlo methods, computation of pi,
simulating stock prices – reasonable assumptions about stock prices, lognormal distribution, Monte
Carlo simulations for investments, Value at Risk (VAR), simulating options and option strategies – price
simulations and Black-Scholes formula, using Monte Carlo methods for pricing options.

Module 6:
Excel Techniques and VBA
Setting up one-dimensional data table, building two-dimensional data table, handling formula cells,
matrix operations, useful financial excel functions, array functions, write functions that can be added to
excel functions.
 Session Plan

Session Topic Type Reading

Session Basic financial calculations – Concept Ref. 1, 5 and 6
1,2,3,4, NPV, IRR, payment schedules and
5,6,7, 8, and loan tables, future value, Theory
9,10,11 pension and accumulation discussio
,12 problems, continuously n
compounded interest; overview
of corporate valuation,
calculating weighted average
cost of capital (WACC),
valuation based on
consolidated statement of cash
flows,
Building a pro-forma model
and overview of financial
analysis

Session Introduction to portfolio Concept Ref. 1, 5 and 6

13, 14, models, calculating efficient and
15, 16 portfolios – how to calculate Theory
efficient portfolios and how to discussio
calculate efficient frontier, n
calculating variance-
covariance matrix, estimating
betas and security market line –
calculate beta for set of assets,
determine equation of security
market line (SML), Efficient
portfolios without short sales,
The Black-Litterman approach
to portfolio optimization.

Session Introduction to options – basic Concept Ref.1, 4 and 6

17,18, option definitions, terminology &
19,20, and payoffs, the binomial Problems
21,22 option pricing model, the
Black-Scholes model –
mechanics of the model, uses of
Black-Scholes formula in
valuation of structured assets,
option Greeks- Delta, Gamma,
Vega, Theta, Rho, and real
options – option to defer, time-
to-build (staged investment)
option, option to alter operating
scale, option to abandon, option
 to switch outputs and inputs,
the growth option.

Session Introduction to bonds, bond Concept Ref.1, 5 and 6

23,24, duration – measurement of &
25,26 sensitivity of a price of a bond Theory
to changes in the interest rate- discussio
Macaulay duration, n
immunization strategies –
simplest duration concept of
Macaulay, modelling the
term structure – simplest term
structure with one bond for
each period, Nelson-Siegel
model, variation of NS model
due to Svensson, calculating
default-adjusted expected
bond returns – Markov
models

Session Generating and using random Concept Ref.1 and 4

27, 28 numbers, introduction to &
Monte Carlo methods, Problems
computation of pi, simulating
stock prices – reasonable
assumptions about stock
prices, lognormal distribution,
Monte Carlo simulations for
investments, Value at Risk
(VAR), simulating options and
option strategies – price
simulations and Black-Scholes
formula, using Monte Carlo
methods for pricing options.

Session Setting up one-dimensional Concept Ref.1 and 5

29,30 data table, building two- &
dimensional data table, Problems
handling formula cells, matrix
operations, useful financial
excel functions, array
functions, write functions that
can be added to excel
functions.
Reference books (Ref.):

1. Benninga S, Financial Modeling, MIT press, Fourth edition.

2. Proctor, S, Building Financial Models.
3. Palepu, Krishna, Paul Healy and Victor Bernard, Business Analysis and Valuation using
Financial Statements, South-western Publishing, Latest Edition
4. Hull, J. C. and Sankarshan B, Options, Futures and other Derivatives by, 7th edition, Pearson
publication
5. Ross, Westerfield, Jaffe, Kakani, Corporate Finance, TMH, Latest edition
6. Brigham and Herhardt, Financial Management Theory and Practice, 14th Edition, Cengage
Publications.

Internal Assessment and Evaluation:

1. Mid-term test: 20 marks
2. Case study/Project: 10 marks
3. Viva voce/Assignments/Project: 10 marks

Instructions:

1. Students are required to bring laptop computers to every session.

2. The laptop should be loaded with MS-Office and the laptop should not be connected to internet.
3. Numerical problems’ softcopy/hardcopy will be will be given in the class.
4. Consistent with the academic policy of KIAMS, the use of computers and other electronic
gadgets inside the classroom is generally prohibited. However, the use of laptops may be
permitted in class solely for the purposes of discussion of the problems and when instructed in
advance by the course instructor. Please note that accessing the internet, recreational programs,
or e-mail and messaging accounts will never be permitted under any circumstances and is
strictly forbidden inside the classroom.