Unit Details

1 Module 1: Introduction to Financial Analytics: Analytical thinking, Role of a Financial

Analyst, News analytics (accessing news using web scrapping) and sentiment analysis
in finance, Data Driven Financial Decision, Decision making under uncertainty,

2 Module 2: Introduction to Analysis of Financial Data Using Statistical Tools: Statistical

concepts; Probability, Normal, Lognormal distribution properties, Data visualization,
Understanding data in finance, cleaning and pre-processing of data, Application of
software on different forms of financial data set- Time Series and Cross Sectional Data

3 Module 3: Financial Modelling: Introduction to Basic Financial Functions in Excel,

Discounted Cash flows, Annuity, PMT, PV, NPV, IRR, Financial modelling using Ratios,
income statement and financial statements using Excel

4 Module 4: Application of Data Science across Financial Services: Learn about Financial
Data Analytics with respect to Data Science in Financial Services, Artificial Intelligence
and Machine Learning in Financial Services, Usage of AI in Algorithmic Stock Trading,
Automated Robo-Advisors, Fraud Detection and Prevention

5 Module 5: Optimal Portfolio Allocation: Capital Allocation Line (CAL) and Optimal
Portfolio, Lending and Borrowing on the CAL, analysis using indifference curves.
CAPM- Features of Markowitz analysis, expected returns from historical averages,
efficient frontier.

6 Module 6: Risk-Return Trade-off & Quadratic Utility: Investments and trade

consumption across time, trade-off between risk and return, decision making under
uncertainty, indifference curves, quadratic utility function, etc.

Unit 1: Module 1: Introduction to Financial Analytics: Analytical thinking, Role of a Financial

Analyst, News analytics (accessing news using web scrapping) and sentiment analysis in finance,
Data Driven Financial Decision, Decision making under uncertainty

Expected Questions:

Q1. What is financial analytics?

Financial analytics is the creation of ad hoc analysis to answer specific business questions and
forecast possible future financial scenarios. The goal of financial analytics is to shape business
strategy through reliable, factual insight rather than intuition.

By offering detailed views of companies' financial data, financial analytics provides the tools for firms
to gain deep knowledge of key trends and take action to improve their performance.

Q2. What are the benefits of financial analytics?

As a subset of business intelligence and enterprise performance management, financial analytics

affects all parts of a business and is crucial in helping companies predict and plan for the future.

Financial analytics involves using massive amounts of financial and other relevant data to identify
patterns to make predictions, such as what a customer might buy or how long an employee's tenure
might be. With a wealth of financial and other relevant data from various departments throughout
their organizations, corporate financial teams are increasingly using this data to help company
leaders make informed decisions and boost the company's value.

By helping businesses understand their top- and bottom-line performance (along with other
indicators, including financial and macroeconomic data), measure and manage their assets, and
forecast variations within the organizations and industries in which they compete, financial analytics
offers insight into organizations' financial status and improves the profitability, cash flow and value of
the business. Financial analytics also helps companies improve income statements and business
processes.

Q3. What are the role of Financial analytics and the CFO?

Business transformation and advances in technology -- from big data to customer analytics software
to data warehouses -- have contributed to companies' move to use financial analytics. The changing
role of the corporate finance department has also influenced this move.

Chief financial officers traditionally relied on historical data and trends to forecast future
performance. However, they are changing their focus as they increasingly tap into technologies, such
as advanced data analytics, machine learning and automation. As finance departments have begun
adopting financial analytics to home in on what's happening in the business and what that's likely to
mean going forward, their roles have changed from information provider to problem solver. Having
more timely access to information is helping companies make quicker, better informed business
decisions.

Many experts consider predictive analytics an essential element in the digital transformation of
finance. A key part of this is the ability to examine historical and new data to assess what's relevant
to a specific company -- be it macroeconomic data, industry trends or petroleum prices -- to improve
forecasting and decision-making.

The application of analytics is crucial in financial services and other data-intensive fields. Financial
services businesses, including investment banks, generate and store more data than just about any
other business in any other sector, mainly because finance is a transaction-heavy industry. While
banks have, for many years, used data to measure and quantify risk, data analysts are now taking on
the role of influential internal consultants, responsible for communicating to senior executives key
insights on how to improve the organization's overall profitability.

Today's financial institutions not only analyze structured data, such as market or trading data, but
also unstructured data, which can include data sources from news outlets, social media and
marketing materials.

Q4. Explain the importance of financial analytics.

Financial analytics can help companies determine the risks they face, how to enhance and extend the
business processes that make them run more effectively, and whether organizations' investments are
focused on the right areas.

Advanced analytics and its ability to leverage big data will enable organizations to rethink their
strategies for solving problems and supporting business decisions. Analytics can also help companies
examine the profitability of products across various sales channels and customers, which market
segments will add more profit to the business and what could have an impact on the business in the
future.

Continuous visibility into financial and operational performance will help with more than just
decision-making; it will also increase visibility regarding the processes that support those decisions.
So, rather than getting data on employee turnover rates and the related costs after the fact, financial
analysts and HR leaders will be able to see what problems employees are having and intervene to
improve performance and prevent costly turnover. Another plus is the potential for improved
electronic linkage of records across the supply chain so that data will only need to be entered once.

Despite the promise of financial analytics, business experts from the academic and corporate worlds
warn against automating bad processes. They note that the processes that provide financial insights
based on historical data are often disconnected and leave serious data gaps. Poor-quality data can
hurt business performance and lead to incomplete or inaccurate customer or prospect data,
ineffective marketing and communications efforts, increased spending and bad decisions. To improve
results, companies should use predictive analytics properly, improve the quality of their data and
manage it effectively.
Q5. What are the types of financial analysis?

Financial analysis refers to the process of evaluating businesses, projects, budgets and other finance-
related entities to determine the stability, solvency, liquidity or profitability of an organization. In
addition to focusing on income statements, balance sheets and cash flow statements, financial
analysis is employed for evaluating economic trends, setting financial policy, formulating long-term
business plans and pinpointing projects or companies for investment.

Types of financial analysis include the following:

1. Horizontal analysis refers to the side-by-side comparison of an organization's financial

performance for consecutive reporting periods. The aim is to determine major shifts in the
data. Later, this information could be applied to a more detailed analysis of financial results.
2. Vertical analysis pertains to the proportional analysis of a financial statement. Each line item
on a financial statement is listed as a percentage of another item -- for example, every line
item on an income statement is provided as a percentage of gross sales, while every line item
on a balance sheet is given as a percentage of total assets.
3. Short-term analysis provides a detailed review of working capital, involving the calculation of
turnover rates for accounts receivable, inventory and accounts payable. Any differences from
the long-term average turnover rate should be studied further because working capital is a
significant user of cash.
4. Multi-company comparison entails tallying and comparing major financial ratios of two
organizations, usually in the same industry sector. The aim is to determine the companies'
relative financial strengths and weaknesses.
5. Industry comparison contrasts the results of a specific business and the average results of an
entire industry. The purpose is to determine any unusual results in comparison to the
industry average.

Key types of financial analytics

Examining financial and other relevant information, financial analytics offers various views of
companies' past, present and future performance. The following are key types of analytics that can
help companies of different sizes:

• Predictive sales analytics may include the use of correlation analysis or past trends to
forecast corporate sales.
• Client profitability analytics helps differentiate between clients who make money for a
company and those who don't.
• Product profitability analytics entails assessing each product individually, rather than
establishing profitability overall at a company.
• Cash-flow analytics employs real-time indicators, including the working capital ratio and cash
conversion cycle, and may include tools such as regression analysis to predict cash flow.
• Value-driven analytics assesses a business' value drivers, or the key "levers" the organization
needs to pull to achieve its goals.
• Shareholder value analytics, which is used to tally the value of a company by examining the
returns it provides to shareholders, is used concurrently with profit and revenue analytics.
Q6.Name the popular Financial analytics software programs.

As the way information is now collected and analyzed presents a significant shift -- along with new
challenges -- software can help reduce the complexity. Financial analysis software can speed up the
creation of reports and present the data in an executive dashboard, a graphical presentation that is
easier to read and interpret than a series of spreadsheets with pivot tables.

Popular financial analysis software programs include the following:

• Oracle Financial Analytics is the modular component of Oracle's integrated family of business
intelligence software applications. It enables insight into the general ledger and provides
visibility into performance against budget and the way staffing costs and employee or
supplier performance affects revenue and customer satisfaction.
• SAP ERP Financial Analytics helps organizations define financial goals, develop business plans
and monitor costs and revenue during execution.
• SAS Business Analytics provides an integrated environment for data mining, text mining,
simulation and predictive modeling -- a mathematical model that predicts future outcomes --
as well as descriptive modeling, a mathematical model that describes historical events and
the relationships that created them.
• IBM Cognos Finance provides out-of-the box data analysis capabilities for sales, supply chain
procurement and workforce management functions.
• NetSuite provides financial dashboards, reporting and analytic functions that allow personal
key performance indicators to be monitored in real time.
• MATLAB allows developers to interface with programs developed in different languages,
which makes it possible to harness the unique strengths of each language for various
purposes.

Q7. What is Financial Analysis?

• Financial analysis is the process of evaluating businesses, projects, budgets, and other
finance-related transactions to determine their performance and suitability. Typically,
financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable
enough to warrant a monetary investment.

• if conducted internally, financial analysis can help fund managers make future business
decisions or review historical trends for past successes.

• If conducted externally, financial analysis can help investors choose the best possible
investment opportunities.

• Fundamental analysis and technical analysis are the two main types of financial analysis.

• Fundamental analysis uses ratios and financial statement data to determine the intrinsic
value of a security.

• Technical analysis assumes a security's value is already determined by its price, and it focuses
instead on trends in value over time.
Q8. What Is Fundamental Analysis?

Fundamental analysis uses ratios gathered from data within the financial statements, such as a
company's earnings per share (EPS), in order to determine the business's value. Using ratio analysis
in addition to a thorough review of economic and financial situations surrounding the company, the
analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number
that an investor can compare with a security's current price in order to see whether the security is
undervalued or overvalued.

Q9. What Is Technical Analysis?

Technical analysis uses statistical trends gathered from market activity, such as moving averages
(MA). Essentially, technical analysis assumes that a security’s price already reflects all publicly
available information and instead focuses on the statistical analysis of price movements. Technical
analysis attempts to understand the market sentiment behind price trends by looking for patterns
and trends rather than analyzing a security’s fundamental attributes.

Q10. What is the role of data analytics in financial decision making?

In finance, this means examining past financial data to predict future trends, evaluate risk, and
decide where to invest resources. The quantitative nature of finance makes data analytics an
essential skill for anyone looking to enter the field.

Q11. What is the purpose of analyzing the financial performance?

That is to say, by analyzing financial statements and ratios, businesses can identify areas of
improvement, reduce costs, and make informed decisions about future investments. In addition, this
technique helps companies compare their performance to industry benchmarks and identify market
trends.

Q12. What is the primary goal of financial analysis?

One of the main tasks of a financial analyst is to analyze a company's financial statements, including
the income statement, balance sheet, and cash flow statement. The main goal of financial analysis
is to measure a company's financial performance over time and against its peers.

Q13. Why is financial analysis important to investors?

Financial statements are important to investors because they can provide information about a
company's revenue, expenses, profitability, debt load, and ability to meet its short-term and long-
term financial obligations.

Q14. What are the 5 components of financial analysis?

The five components of financial analysis are liquidity analysis, solvency analysis, profitability
analysis, efficiency analysis, and market analysis. These components help assess an organization's
financial health, performance, and viability from different perspectives.

Q15. What is sentiment analysis in financial analytics?

Sentiment analysis is the use of natural language processing, text analysis, computational linguistics
and biometrics to systematically identify, extract, quantify and study affective states and subjective
information. The most common use of sentiment analysis in the financial sector is the analysis of
financial news, particularly. Sentiment analysis aims to determine the sentiment strength from a
textual source for good decision making. This work focuses on application of sentiment analysis in
financial.

Q16. What are the applications of sentiment analysis in finance?

The application scenarios include corporate disclosures, annual reports, earning calls, financial news,
social media interactions, and more [170, 183]. Sentiment analysis is a suitcase problem and domain-
dependent.

Q17. What is the main purpose of sentiment analysis?

Sentiment analysis is the process of analyzing digital text to determine if the emotional tone of the
message is positive, negative, or neutral. Today, companies have large volumes of text data like
emails, customer support chat transcripts, social media comments, and reviews.

Q18. What are the three types of sentiment analysis?

The three most popular types, emotion based, fine-grained and aspect-based sentiment
analysis (ABSA) all rely on the underlying software's capacity to gauge something called polarity, the
overall feeling that is conveyed by a piece of text.

Q19. Which method is best for sentiment analysis?

Automated or Machine Learning Sentiment Analysis. Automated sentiment analysis relies on

machine learning (ML) techniques. In this case a ML algorithm is trained to classify sentiment based
on both the words and their order. The success of this approach depends on the quality of the
training data set and the algorithm.

Q20. What are the key components of sentiment analysis?

The primary components of sentiment analysis algorithms are customer data, polarity categories,
emotion detection, aspect-based classifiers, intent analysis, language classifiers, rules, and machine
learning classifiers. Not all sentiment analysis algorithms will use all of these components or use
them in the same way.

Q21. What are the three types of financial data?

The three core financial statements are 1) the income statement, 2) the balance sheet, and 3) the
cash flow statement. These three financial statements are intricately linked to one another. Analyzing
these three financial statements is one of the key steps when creating a financial model.

ach statement provides a unique lens and set of data with enriching insights to transform your
overall strategy.

1. Balance sheet

The balance sheet is an item-by-item breakdown of everything the company owns, including assets,
liabilities, shareholder equity, and other variables during a specific moment in time. Balance sheets
also communicate exactly how much a company is worth, totaling the value of these variables into a
single monetary total.

The following is a breakdown of a balance sheet’s format:

• Assets: What does the company own? Buildings, inventory, cash—everything is listed as an
item on the balance sheet. These can be further broken down into current assets (cash,
 inventory, accounts receivable) and non-current/fixed assets (property, equipment, patents,
licenses)

• Liabilities: What does the company owe? Long-term debts, accrued expenses, deferred
revenue—every outstanding expense the company still has to pay is listed in this section. The
cost of every liability is also totaled up to reflect a single price point

• Equity: What is owed to the owners of the company? Whatever money is left after liabilities
are accounted for goes to the owners of the business. This is broken down into categories
similar to those in the statement of shareholders’ equity, such as common stock and
preferred stock

A company’s balance sheet and other financial statements can be analyzed from multiple points of
view.

Internal balance sheet insights

The internal view encompasses the needs and perspectives of business leaders, employees,
shareholders, and other internal players. Invested parties use the balance sheet to get a snapshot
view of whether the company is succeeding or failing. Depending on their findings, the internal
players may make policy or financial changes to remedy shortcomings or bolster successes.

External balance sheet insights

The external view of a balance sheet is typically for potential investors and regulators who may have
specific requirements for what information to share and how to present it. For those interested in
purchasing shares, the balance sheet offers insight into what resources are available to the business
and how those resources are financed. Based on their findings (along with any additional insights
gleaned from the risk report), potential investors will determine if the company is worth investing in.

You cannot gather these insights from a single document. Comparing your current balance sheet to
previous periods will reveal potential trends that can be compared and assessed.

2. Income statement

Sometimes referred to as a profit and loss statement, income statements describe what the company
did with the money it earned and spent. This essentially reveals its activities between balance sheets.
Income statements include all revenues, expenses, gains, and losses that occurred during a period.
This is often broken down into the following categories:

• Revenue: How much money a business earns during the recorded period

• Costs of goods sold (COGS): The cost behind what it takes to make the units sold

• Gross profit: Total revenue minus COGS

• Expenses: How much money the company spent during the recorded period

• Operating income: Total profits minus any operating expenses, such as labor

• EBITDA: Earnings before interest, depreciation, taxes, and amortization

• Depreciation: How much value its assets have lost over time

• Income before taxes: Income minus costs but before the exclusion of applicable taxes
 • Net income: Total income after all costs are subtracted

• Earnings per share: Income divided by the total number of outstanding shares

Income statements paint a picture of a company’s financial performance. Therefore, potential

investors gain further insight into the company’s profitability. Additionally, investors can compare
income statements against projected earnings to determine whether or not a company is on the
right track.

3. Cash flow statement

Cash flow statements show how the company uses its revenue. These give investors and
shareholders a direct look into how effectively the company is spending its money, particularly in the
context of long-term and short-term investments.

A cash flow statement is broken down into three categories:

• Financing activities: Cash flow from debt or equity financing

• Investing activities: Cash flow from purchasing or selling assets using free cash, which may
include real estate investments, vehicles, or the purchase of non-physical assets such as
patents and licenses

• Operating activities: Cash flow that encompasses regular goods and services, including both
the associated revenue and expenses

Direct vs indirect cash flow

Cash flow statements cover two forms of cash flow methods: direct and indirect. The direct cash flow
method is a simplified approach to seeing how cash flows in and out of your business. Cash flow
statements using this method will attribute cash movement to actual items, like salaries, vendor
payments, or interest payments.

An indirect cash flow method starts with your net income and works backward. Using that net
income as a base, a company would add non-cash expenses (like depreciation), non-cash incomes,
and any net adjustments between current assets and liabilities. Direct cash flow ignores depreciation
and other non-cash factors.

The purpose of cash flow statements

Cash flow statements, like all other financial statements, offer a clear perspective for investors. If the
cash flow analysis observes a healthy, consistent cash flow, that is going to inspire more investors
than one that is uneven or unsustainable. Internally, a department head might observe irregularities
or inefficiencies in the cash flow, which may inspire restructuring or an adjustment of the company’s
activities.

4. Statements of shareholders’ equity

The statement of shareholders’ (or stockholders’) equity outlines the changes in ownership interests
for the company’s shareholders.

The statement of changes in equity is a relatively straightforward calculation: Simply find the
difference between a company’s total assets and total liabilities. However, this financial statement
goes deeper than the calculation alone. The statement of shareholders’ equity includes a few key
components:
 • Common stock: A type of ownership stake in the company that comes with voting rights on
corporate decisions—common stockholders have the lowest priority claim on a company’s
assets

• Preferred stock: A special ownership stake that offers stockholders a higher claim to a
company’s assets and earnings than common stockholders—companies report preferred
stocks at face value in the statement of shareholder’s equity

• Retained earnings: The total earnings of a company after it distributes dividends to its
shareholders

• Treasury stock: Stocks that the company repurchased. This is often done to avoid hostile
takeovers or to temporarily boost stock prices. However, shareholder equity is reduced by
the amount of money spent to repurchase these stocks

• Unrealized gains and losses: The changes in pricing for investments that have not yet been
cashed in. Unrealized gains occur when the investment increases in value but hasn’t been
cashed in, while unrealized losses occur with a decrease in investment value

• Additional paid-up capital: The excess amount investors pay over the face value (aka par
value) of the company’s stock

The statement of shareholders’ equity report is created with investors in mind, as it gives them
important information and context into why their equity increases or decreases. It also alerts them
to what is and isn’t working in the financials of the company, which may influence future investment
decisions.

Module 2: Introduction to Analysis of Financial Data Using Statistical Tools: Statistical concepts;
Probability, Normal, Lognormal distribution properties, Data visualization, Understanding data in
finance, cleaning and pre-processing of data, Application of software on different forms of financial
data set- Time Series and Cross Sectional Data

Expected Qs.

Q1. What is the normal distribution and its properties?

Normal distribution, also known as the Gaussian distribution, is a probability distribution that is
symmetric about the mean, showing that data near the mean are more frequent in occurrence
than data far from the mean. The normal distribution appears as a "bell curve" when graphed.

Key Features of Normal Distribution

• Symmetry: The normal distribution is symmetric around its mean. This means the left side
of the distribution mirrors the right side.

• Mean, Median, and Mode: In a normal distribution, the mean, median, and mode are all
equal and located at the center of the distribution.

• Bell-shaped Curve: The curve is bell-shaped, indicating that most of the observations
cluster around the central peak and the probabilities for values further away from the
mean taper off equally in both directions.
 • Standard Deviation: The spread of the distribution is determined by the standard
deviation. About 68% of the data falls within one standard deviation of the mean, 95%
within two standard deviations, and 99.7% within three standard deviations.

Q2. What are the 5 critical properties of a normal distribution?

Properties of Normal Distribution are,

• Normal Distribution Curve is symmetric about mean.

• Normal Distribution is unimodal in nature, i.e., it has single peak value.

• Normal Distribution Curve is always bell-shaped.

• Mean, Mode, and Median for Normal Distribution is always same.

• Normal Distribution follows Empirical Rule.

Q3. What is the Empirical Rule of Standard Deviation?

Generally, the normal distribution has a positive standard deviation and the standard deviation
divides the area of the normal curve into smaller parts and each part defines the percentage of
data that falls into a specific region This is called the Empirical Rule of Standard Deviation in
Normal Distribution.

Empirical Rule states that,

• 68% of the data approximately fall within one standard deviation of the mean, i.e. it falls
between {Mean – One Standard Deviation, and Mean + One Standard Deviation}

• 95% of the data approximately fall within two standard deviations of the mean, i.e. it falls
between {Mean – Two Standard Deviation, and Mean + Two Standard Deviation}

• 99.7% of the data approximately fall within a third standard deviation of the mean, i.e. it
falls between {Mean – Third Standard Deviation, and Mean + Third Standard Deviation}

• Normal Distribution Graph

 •
• Studying the graph it is clear that using Empirical Rule we
distribute data broadly in three parts. And thus, empirical rule
is also called “68 – 95 – 99.7” rule.

Q4. What are Uses of Normal Distribution?

Various uses of Normal Distribution are,

• For studying vrious Natural Phenomenon

• For studying of Financial Data.

• In Social Sciense for studying and predicting various parameters, etc.

Q5. What are Limitations of Normal Distribution?

Normal Distribution is an extremely important Statical concept, but even it has some limitations
such as,

• Various distribution of data does not follow Normal Distribution and thus it is unable to
comment on these data.

• To much relliance of Normal Distriution or Bell curve is not a good way to prdict data as it
is not 100% accurate, etc.

Q6. What is log normal distribution?

A lognormal distribution is common in statistics and probability theory. Lognormal distribution is

also known as the Galton or Galton’s distribution, being named after Francis Galton, a statistician
during the English Victorian Era.
By definition, the lognormal distribution is the discrete and ongoing distribution of a random
variable, the logarithm of which is normally distributed. In other terms, lognormal distribution
follows the concept that instead of having the original raw data normally distributed, the
logarithms of this raw data that are computed are also normally distributed.

• A lognormal distribution is the discrete and ongoing distribution of a random variable, the
logarithm of which is normally distributed. In other terms, lognormal distribution follows
the concept that instead of seeing the original raw data normally distributed, the
logarithms of the raw data computed are also normally distributed.

• Lognormal distribution is also known as the Galton or Galton’s distribution, named after
Francis Galton, a statistician during the English Victorian Era.

• The lognormal distribution model is considered to be very useful in the fields of medicine,
economics, and engineering.

Q7. Lognormal vs. Normal Distribution

Lognormal distributions tend to be used together with normal distributions, as lognormal

distribution values are derived from normally distributed values through mathematical means.
One key difference between the two is that lognormal distributions contain only positive numbers,
whereas normal distribution can contain negative values.

Another key difference between the two is the shape of the graph. Normally distributed data
forms a symmetric bell-shaped graph, as seen in the previous graphs. In contrast, lognormally
distributed data does not form a symmetric shape but rather slants or skews more towards the
right.

Q8. How to find lognormal in excel?

Lognormal distribution can be done in Excel. It is found in the statistical functions as

LOGNORM.DIST.1

Excel defines it as the following:

LOGNORM.DIST (x,mean,standard_dev,cumulative)

Returns the lognormal distribution of x, where ln(x) is normally distributed with parameters mean
and standard_dev.

To calculate LOGNORM.DIST in Excel you will need the following:

x = value at which to evaluate the function

Mean = the mean of ln(x)

Standard Deviation = the standard deviation of ln(x) which must be positive

Q9. What is the application of LOGNORMAL.INV Function in EXCEL?

Inverse Lognormal Distribution Excel

The LOGNORM.INV Function[1] is categorized under Excel Statistical functions. It will calculate the
inverse lognormal distribution in Excel at a given value of x. We can use the function to analyze
data that’s been logarithmically transformed.

LOGNORMAL distribution is often used in financial analysis to help make investment decisions. It is
often used in analyzing stock prices, as normal distribution cannot be used to model stock prices.
This is because the normal distribution includes a negative side and stock prices cannot fall below
zero.

The LOGNORM.INV function is useful in financial analysis when we are given the probability and
we wish to find the value of x. For example, we can use the function to know the probability of a
stock price rising and want to find the stock price that is x.

Also, the function is useful in pricing options. The Black-Scholes model uses the lognormal
distribution as its basis to determine option prices.

Formula

=LOGNORM.INV(probability,mean,standard_dev)

The LOGNORM.INV function uses the following argument:

1. Probability (required argument) – This is the probability associated with the lognormal
distribution.

2. Mean (required argument) – The mean of In(x).

3. Standard_dev (required argument) – This is the standard deviation of In(x).

Remember, If p = LOGNORM.DIST(x,…), then LOGNORM.INV(p,…) = x.

Q10. What do you mean by time series and cross sectional data?

Sometimes called time-stamped data, time series data is a time order indexed sequence of data
points. Typically, these data points track change over time and consist of successive measurements
over a fixed time interval made from the same source.

Time series data is data that is recorded over consistent intervals of time. Cross-sectional data
consists of several variables recorded at the same time. Pooled data is a combination of both time
series data and cross-sectional data.

Time series analysis is a subset of predictive analytics that collects data over regular periods. Such
analysis is used by companies to predict their revenue and the impact of major business decisions.
In short, it adds more value to business growth.

With this form of analytics, you can learn if your company is making more money during the
summer months or at the beginning of the fiscal year. You can also analyze weather data to see if
winter storms caused any loss in revenue.

Q11. What are the four components of a time series?

Here are the 4 major components:

• Trend component.
 • Seasonal component.

• Cyclical component.

• Irregular component

1. Trend component: This is useful in predicting future movements. Over a long period of time,
the trend shows whether the data tends to increase or decrease. The term “trend” refers to an
average, long-term, smooth tendency. Not all increases or decreases have to occur
simultaneously. Different sections of time show varying tendencies in terms of trends that are
increasing, decreasing, or stable. There must, however, be an overall upward, downward, or
stable trend.

2. Seasonal component: The seasonal component of a time series is the variation in some
variable due to some predetermined patterns in its behavior. This definition can be used for
any type of time series including individual commodity price quotes, interest rates, exchange
rates, stock prices, and so on.

In many applications, seasonal components can be represented by simple regression

equations. This approach is sometimes referred to as a “seasonalized regression” or a “bimodal
regression”

3. Cyclical component: The cyclical component in a time series is the part of the movement in
the variable which can be explained by other cyclical movements in the economy.

In other words, this term gives information about seasonal patterns. It is also called the long-
period (LP) effect or boom-bust process.

For example, during recessions, business cycles are usually characterized by slower growth
rates than before the recession started.

4. Definition of irregular component: The irregular component is the part of the movement in
the variable which cannot be explained by cyclical movements in the economy.

In other words, this term gives information about non-seasonal patterns.

This term refers to changes that are not cyclical. These include boom-bust processes,
permanent changes in the long-term trend of a variable, or “not seasonally adjusted”
information which is not normally found in national income and product accounts (such as
depreciation, research and development expenditures, and agricultural subsidies).

Q12.What is Time Series Analysis and What is Its Importance?

Time series data analysis is the way to predict time series based on past behavior. Prediction is
made by analyzing underlying patterns in the time-series data.

E.g., Predicting the future sales of a company by analyzing its past performance.

Predicting the state of the economy of a country by analyzing various factors affecting it. These
series are generally time series, and they contribute to the economy.
The importance of time series analysis for science, industry, and commerce, is as follows:

The study of past history is necessary for forecasting future events.

Time series analysis shows why trends exist in past data and how they may be explained by
underlying patterns or processes.

Time series analysis is a basic tool for the analysis of natural systems, which cannot be understood
without it. For example, climate cycles and fluctuations in the economy, as well as volcanic
eruptions and earthquakes, are examples of natural systems, whose behavior can best be studied
using time series analysis.

Time series analysis gives a way to predict the future. It is essential in engineering, finance,
business, and the economy to make it easy for investors, customers, or engineers to make the
proper decisions.

Q13. How to Understand A Time Series?

The preliminary step in understanding a time series is its visualization. The time-series visualization
plots data points on the y-axis w.r.t time on the x-axis. The graph may show some of the following
features:

Trend: A trend is a long-running pattern of time series. It may be upwards or downwards.

Seasonality: The repetitive patterns at certain times of year are called seasonality. For example,
sales of cakes will peak every December in the US because of Christmas.

Cyclical pattern: The data shows fluctuations at any time of the year.

Residual: The data remaining after removing the above three is called Residual.

Time-series analysis visualization

Figure1: Time-series visualization of Index of Industrial Production (IIP) of India.

As shown in Figure 1, there is an upward trend in the graph, and there is a repetitive pattern every
year representing seasonality.

Removing trend and seasonality is sometimes important for analyzing a time series as seasonality
may hinder getting the actual randomness of the data and give its cyclical pattern in the prediction.

Q14. What are Stationary and Non-stationary Time Series?

The time series which has constant mean and variance is called stationary time series. It is
recommended to have the stationary time series for better analysis.

The predictions on non-stationary series may give wrong values.

To check whether a series is stationary or not, there are several tests in the literature.

One of them is the Augmented Dickey-Fuller (ADF) test which is a unit root test. Its null hypothesis
is that the series is non-stationary.

If the p-value is less than 0.05, the null hypothesis can be rejected, and the series can be
considered stationary.

Q15. How to Make A Time Series Stationary?

A series can be made stationary by various methods like:

1. Difference Transform: Subtracting previous value with current value is called differencing.
It is done to remove the dependency of values on time. One can check the differenced
series with the ADF test for stationary.

2. Second differencing: If the result of the ADF test on the differenced series shows that the
series is still non-stationary, then one can subtract the differenced series again.

3. Removing trend and seasonality by using HP-filter or band-pass filters and X12 ARIMA
analysis.

Is It Necessary to Remove Trend And Seasonality?

No. There are some models like Prophet, SARIMAX, etc., which take care of seasonality while
modeling. The basic ARIMA model needs the de-seasonal data.

Q16. Which Algorithms Can be Used for Time Series Forecasting?

There are various methods for analyzing time-series data:

 1. Autoregressive Integrated Moving Average (ARIMA) Models

2. Seasonal Autoregressive Integrated Moving Average (SARIMA) Models

3. Vector Autoregression (VAR)

4. Exponential Smoothing models

5. Prophet model.

Once you have the data ready, you can divide the dataset into train and test data, train any of the
above models, and test the performance using test data.

Q17. How to Compare Performance of Different Models?

The models can be compared on various metrics like:

1. MSE (Mean squared error)

2. RMSE(Root Mean Squared error)

3. MAPE(Mean Absolute Percentage Error) etc.

Out of these metrics, MAPE has generally been considered a good metric for comparing models.

Q17. What are The Business Applications of Time Series Analysis?

1. The forecasting of future values and the identification of trends using linear regression
methods, moving averages, variance forecasts, and wavelets

2. Short-term time series modeling and ARIMA models

3. Seasonal analysis using univariate (trends) and multivariate (stratification) techniques

4. Space-time processes

5. Measurement uncertainty

6. Research using regression models

7. Robustness

8. Commodity markets

9. Forecasting (all levels)

10. Fractional statistics

11. Finding anomalies

Q18. What are The Objectives of Time Series Analysis?

1. To study the trend of the series

2. To compute the time-series data

3. To create a new data set from the existing one

4. To analyze and compare the old and new data sets

 5. To detect the causality among the variables of the data set

6. To study cross-sectional relationships between different types of variables

7. To interpret the economic significance of the series data and their relationship with other
factors in the economy

Module 3: Financial Modelling: Introduction to Basic Financial Functions in Excel, Discounted Cash
flows, Annuity, PMT, PV, NPV, IRR, Financial modelling using Ratios, income statement and
financial statements using Excel

Q1. What is basic financial Modelling?

Financial modelling is the process of creating a summary of a company's expenses and earnings in
the form of a spreadsheet that can be used to calculate the impact of a future event or decision.

• Financial modelling is a numerical representation of some or all aspects of a company's

operations.

• Financial models are used to estimate the valuation of a business or to compare companies
to their industry competitors.

• Various models exist that may produce different results. A model is only as good as the
inputs and assumptions that go into it.

Financial models are used to estimate the valuation of a business or to compare businesses to
their peers in the industry. They are also used in strategic planning to test various scenarios,
calculate the cost of new projects, decide on budgets, and allocate corporate resources.

Q2. What Is Financial Modelling Used for?

A financial model is used for decision-making and financial analysis by people inside and outside of
companies. Some of the reasons a firm might create a financial model include the need to raise
capital, grow the business organically, sell or divest business units, allocate capital, budget,
forecast, or value a business.

Q3. What is financial Modelling in Excel?

A financial model in Excel is a graphical representation of financial data. Financial experts like
accountants, investors or bankers can use Excel to create models to track investments, predict
profits and create more organized data sets for clients or internal reviews.

Q4. What are the most popular 8 excel functions for finance modelling?

Top 8 Excel Functions for Finance

You need to know these 8 functions and formulas simply and clearly. You will be ready to handle
any financial problems in Excel when you follow this guide. All of these formulas and functions are
useful on their own, but they can also be used in combination to make them even more powerful.
These combinations will be highlighted whenever possible.

1: XNPV
Formula: =XNPV(discount_rate, cash_flows, dates)

For finance professionals, XNPV is the most useful formula in Excel. For a valuation analysis to
determine a company's value, a series of cash flows must be calculated to determine its Net
Present Value (NPV).

By taking specific dates for cash flows into account, XNPV is much more useful and precise than
regular NPV in Excel.

2: XIRR

Formula: =XIRR(cash flows, dates)

A similar function to XNPV is XIRR, which calculates the internal rate of return for a series of cash
flows based on specific dates.

Since the time periods between cash flows are unlikely to all be the same, XIRR should always be
used over regular IRR.

3: MIRR

Formula: =MIRR(cash flows, cost of borrowing, reinvestment rate)

One of the most important things for finance professionals is to understand the internal rate of
return in its many variations. In this formula, M stands for Modified, and it is especially useful
when investing the cash from one investment in another.

Suppose a private business invested its cash flow in government bonds.

A high-returning business with an 18% IRR that reinvests cash in a bond at only 8% will result in a
combined IRR that is considerably lower than 18%.

4: PMT

Formula: =PMT(rate, number of periods, present value)

Finance professionals who work with real estate financial models often use this function in Excel. It
is easiest to think of the formula as a mortgage payment calculator.

You can calculate how much the payments will be given a number of time periods (years, months,
etc.) and the total loan value (e.g., mortgage).

In this way, both principal and interest are included in the total payment.

5: IPMT

Formula: = IPMT(rate, current period #, total # of periods, present value)

A fixed debt payment includes an interest component calculated by IPMT. In conjunction with the
PMT function above, this Excel function works very well. Taking the difference between PMT and
IMPT in each period, we can arrive at the principal payments for each period by separating out
interest payments.

6: EFFECT

Formula: =EFFECT(interest rate, # of periods per year)

Non-annual compounding interest rates are calculated in Excel using this finance function. In
particular, finance professionals involved in lending and borrowing should know about this feature
in Excel.

In the example above, a compounded monthly interest rate of 20.0% is actually a 21.94% annual
interest rate.

7: DB

Formula: =DB(cost, salvage value, life/# of periods, current period)

Accounting and finance professionals will find this Excel function very useful. This formula allows
Excel to calculate your depreciation expense for each period without building a large Declining
Balance (DB) schedule.

8: RATE

Formula: =RATE(# of periods, coupon payment per period, price of the bond, the face value of the
bond, type)

A security's Yield to Maturity can be calculated using the RATE function. If you want to calculate
the average annual rate of return on bonds, you can use this calculator.

Q5. What are the 3 basic financial models?

There are many different types of financial models. In this guide, we will outline the top ten most
common models used in corporate finance by financial modeling professionals.

Here is a list of the ten most common types of financial models:

1. Three-Statement Model

2. Discounted Cash Flow (DCF) Model

3. Merger Model (M&A)

4. Initial Public Offering (IPO) Model

5. Leveraged Buyout (LBO) Model

6. Sum of the Parts Model

7. Consolidation Model

8. Budget Model

9. Forecasting Model

10. Option Pricing Model

1. Three-Statement Model

The three-statement model is the most basic setup for financial modeling. As the name implies,
the three statements (income statement, balance sheet, and cash flow) are all dynamically linked
with formulas in Excel. The objective is to set it up so all the accounts are connected and a set of
assumptions can drive changes in the entire model.

2. Discounted Cash Flow (DCF) Model

The DCF model builds on the three-statement model to value a company based on the Net Present
Value (NPV) of the business’s future cash flow. The DCF model takes the cash flows from the three-
statement model, makes some adjustments where necessary, and then uses the XNPV function in
Excel to discount the cash flows back to today at the company’s Weighted Average Cost of Capital
(WACC). These types of financial models are used in equity research and other areas of the capital
markets.

3.Merger Model (M&A)

The M&A model is a more advanced model used to evaluate the pro forma accretion/dilution of a
merger or acquisition. It’s common to use a single tab model for each company, where the
consolidation of Company A + Company B = Merged Co. The level of complexity can vary widely.
This model is most commonly used in investment banking and/or corporate development.

4. Initial Public Offering (IPO) Model

Investment bankers and corporate development professionals also build IPO models in Excel to
value their business in advance of going public. These models involve looking at comparable
company analysis in conjunction with an assumption about how much investors would be willing
to pay for the company in question. The valuation in an IPO model includes “an IPO discount” to
ensure the stock trades well in the secondary market.

5. Leveraged Buyout (LBO) Model

A leveraged buyout transaction typically requires modeling complicated debt schedules and is an
advanced form of financial modeling. An LBO is often one of the most detailed and challenging of
all types of financial models, as the many layers of financing create circular references and require
cash flow waterfalls. These types of models are not very common outside of private equity or
investment banking.

6. Sum of the Parts Model

This type of model is built by taking several DCF models and adding them together. Next, any
additional components of the business that might not be suitable for a DCF analysis (e.g.,
marketable securities, which would be valued based on the market) are added to that value of the
business. So, for example, you would sum up (hence “sum of the parts”) the value of business unit
A, business unit B, and investments C, minus liabilities D to arrive at the Net Asset Value for the
company.

7. Consolidation Model

This type of model includes multiple business units added into one single model. Typically, each
business unit has its own tab, with a consolidation tab that simply sums up the other business
units. This is similar to a Sum of the Parts exercise where Division A and Division B are added
together and a new, consolidated worksheet is created. Check out CFI’s free consolidation model
template.

8. Budget Model
This is used to model finance for professionals in financial planning & analysis (FP&A) to get the
budget together for the coming year(s). Budget models are typically designed to be based on
monthly or quarterly figures and focus heavily on the income statement.

9. Forecasting Model

This type is also used in financial planning and analysis (FP&A) to build a forecast that compares to
the budget model. Sometimes the budget and forecast models are one combined workbook and
sometimes they are totally separate.

10. Option Pricing Model

The two main types of option pricing models are binomial tree and Black-Scholes. These models
are based purely on mathematical formulas rather than subjective criteria and, therefore, are
more or less a straightforward calculator built into Excel.

Q6.What are the 4 components of financial modeling?

The four major components of financial modeling are assumptions, financial statement analysis,
valuation, and sensitivity analysis. Assumptions involve making educated guesses about the future
performance of a business.

Q7. What is PMT in Excel?

PMT, one of the financial functions, calculates the payment for a loan based on constant payments
and a constant interest rate. Use the Excel Formula Coach to figure out a monthly loan payment.

Q8. What Is Present Value (PV)?

Present value (PV) is the current value of an expected future stream of cash flow. It is based on the
concept of the time value of money, which states that a dollar today is worth more than it is
tomorrow.

PV helps investors determine what future cash flows will be worth today, allowing them to
understand the value of an investment and thereby choose between different possible
investments. Present value can be calculated relatively quickly using Microsoft Excel.

Formula for Present Value (PV) in Excel

The formula for calculating PV in Excel is:

=PV(rate, nper, pmt, [fv], [type])

• RATE = Interest rate per period

• NPER = Number of payment periods

• PMT = Amount paid each period (if omitted—it’s assumed to be 0 and FV must be
included)

• [FV] = Future value of the investment (if omitted—it’s assumed to be 0 and PMT must be
included)
 • [TYPE] = When payments are made (0, or if omitted—assumed to be at the end of the
period, or 1—assumed to be at the beginning of the period)

Comprehensive List of 50 Essential Financial Modeling Formulas: Unlocking Insights in Excel for
Investment Analysis, Budgeting, Forecasting

General Formulas:

1. Sum Function:Usage: Adds up a range of numbers.Example: =SUM(A1:A10)

2. Average Function:Usage: Calculates the average of a range of

numbers.Example: =AVERAGE(B1:B5)

3. Count Function:Usage: Counts the number of cells that contain

numbers.Example: =COUNT(C1:C20)

4. Min/Max Function:Usage: Finds the minimum or maximum value in a

range.Example: =MIN(D1:D15)

Time Value of Money (TVM) Formulas:

1. Future Value (FV):Usage: Calculates the future value of an investment.Example: =FV(rate,

nper, pmt, pv)

2. Present Value (PV):Usage: Calculates the present value of future cash

flows.Example: =PV(rate, nper, pmt, fv)

Discounted Cash Flow (DCF) Formulas:

1. Net Present Value (NPV):Usage: Calculates the net present value of an

investment.Example: =NPV(rate, cashflow1, cashflow2, ...)

2. Internal Rate of Return (IRR):Usage: Calculates the internal rate of return for an
investment.Example: =IRR(range of cash flows)

Debt and Interest Formulas:

1. Interest Expense:Usage: Calculates the interest expense on debt.Example: =RATE(nper,

pmt, pv, fv)

2. Debt Amortization:Usage: Calculates the principal repayment on a

loan.Example: =PPMT(rate, per, nper, pv, fv)

Profitability Formulas:

1. Gross Profit Margin:Usage: Calculates the percentage of revenue that exceeds the cost of
goods sold.Example: (Revenue - Cost of Goods Sold) / Revenue

2. Net Profit Margin:Usage: Calculates the percentage of net income to revenue.Example: Net
Income / Revenue

Ratio Analysis Formulas:

1. Return on Investment (ROI):Usage: Measures the return on an investment relative to its

cost.Example: ROI = (Net Profit / Cost of Investment) * 100
 2. Current Ratio:Usage: Measures a company's ability to cover its short-term liabilities with
its short-term assets.Example: Current Assets / Current Liabilities

Stock Valuation Formulas:

1. Earnings Per Share (EPS):Usage: Measures a company's profitability per outstanding share
of common stock.Example: EPS = Net Income / Average Shares Outstanding

2. Price to Earnings (P/E) Ratio:Usage: Measures the ratio of a company's share price to its
earnings per share.Example: P/E Ratio = Market Price per Share / Earnings per Share

Forecasting Formulas:

1. Linear Regression:Usage: Predicts a dependent variable based on the linear relationship

with one or more independent variables.Example: =LINEST(y_range, x_range)

2. Exponential Smoothing:Usage: Forecasts future values by giving more weight to recent

data.Example: =FORECAST.ETS(series, alpha, beta, gamma, seasonality)

Sensitivity Analysis Formulas:

1. Scenario Analysis:Usage: Examines the effect of different scenarios on financial

outcomes.Example: Varies input assumptions to observe impact on NPV or IRR.

2. Data Tables:Usage: Displays multiple outcomes based on different input

values.Example: =TABLE(ROW_INPUT, COLUMN_INPUT)

Budgeting and Planning Formulas:

1. Variance Analysis:Usage: Compares actual financial outcomes with budgeted or expected

values.Example: Actual - Budget

2. Forecast vs. Actual:Usage: Compares forecasted values with actual

outcomes.Example: Forecast - Actual

Capital Budgeting Formulas:

1. Payback Period:Usage: Calculates the time it takes to recover the initial

investment.Example: Payback Period = Initial Investment / Annual Cash Flow

2. Discount Payback Period:Usage: Accounts for time value of money in payback period
calculation.Example: Discounted Payback Period = Discounted Initial Investment / Annual
Discounted Cash Flow

Working Capital Management Formulas:

1. Cash Conversion Cycle (CCC):Usage: Measures the time it takes to convert resources into
cash flow.Example: CCC = Days Inventory Outstanding + Days Sales Outstanding - Days
Payable Outstanding

2. Days Sales Outstanding (DSO):Usage: Measures the average number of days a company
takes to collect revenue after a sale.Example: DSO = (Accounts Receivable / Total Credit
Sales) * Days in Period

Regression Analysis Formulas:

3. Coefficient of Determination (R-squared):Usage: Measures the proportion of the variance
in the dependent variable that is predictable.Example: R-squared = 1 - (SSR / SST)

4. Standard Error of the Estimate:Usage: Estimates the standard deviation of the errors in a
regression analysis.Example: =STEYX(y_range, x_range)

Dividend Discount Model (DDM) Formulas:

5. Dividend Yield:Usage: Measures the annual dividend income relative to the stock's market
price.Example: Dividend Yield = Annual Dividend per Share / Market Price per Share

6. Gordon Growth Model:Usage: Calculates the present value of an infinite series of future
dividends.Example: =D1 / (r - g)

Monte Carlo Simulation Formulas:

7. Random Number Generation:Usage: Generates random numbers for simulation

purposes.Example: =RAND()

8. Simulation Iterations:Usage: Runs multiple iterations of a calculation to simulate different

outcomes.Example: =ITERATE(function, iterations)

Option Pricing Formulas:

9. Black-Scholes Model:Usage: Calculates the theoretical price of European-style

options.Example: =BSOPTIONPRICE(S, X, T, r, sigma)

10. Implied Volatility:Usage: Estimates the future volatility of an underlying

asset.Example: =IMPLIEDVOL(OptionPrice, S, X, T, r)

Sensitivity and Scenario Analysis Formulas:

11. Delta:Usage: Measures the sensitivity of an option's price to changes in the underlying
asset's price.Example: =DELTA(OptionPrice, S, X, T, r, sigma)

12. Gamma:Usage: Measures the rate of change of an option's delta concerning the underlying
asset's price.Example: =GAMMA(OptionPrice, S, X, T, r, sigma)

Time Series Analysis Formulas:

13. Moving Average:Usage: Smooths out fluctuations in data to identify trends over a specified
period.Example: =MOVINGAVERAGE(series, period)

14. Exponential Moving Average (EMA):Usage: Gives more weight to recent data points in a
moving average.Example: =EMA(series, alpha)

15. Real Estate Investment Formulas:

16. Capitalization Rate (Cap Rate):Usage: Measures the return on a real estate investment
based on its income.Example: Cap Rate = Net Operating Income / Current Market Value

17. Return on Equity (ROE):Usage: Measures the return on investment in real estate relative to
equity.Example: ROE = Net Income / Equity

Probability and Statistics Formulas:

 18. Probability Distribution Functions:Usage: Calculates probabilities based on different
statistical distributions (e.g., normal, binomial).Example: =NORM.DIST(x, mean,
standard_dev, cumulative)

19. Correlation Coefficient:Usage: Measures the strength and direction of a linear relationship
between two variables.Example: =CORREL(range1, range2)

20. Cost of Capital Formulas:

21. Weighted Average Cost of Capital (WACC):Usage: Calculates the average rate of return a
company is expected to pay to its investors.Example: WACC = (E/V * Re) + (D/V * Rd * (1 -
Tax Rate))

22. Cost of Equity (Re):Usage: Calculates the rate of return required by an investor to hold
equity in a company.Example: Re = Rf + Beta * (Rm - Rf)

23. Forecasting and Regression Formulas:

24. Coefficient of Variation (CV):Usage: Measures the relative variability of a set of data
points.Example: CV = (Standard Deviation / Mean) * 100

25. Autoregressive Integrated Moving Average (ARIMA):Usage: Models time-series data to

understand and predict future values.Example: =ARIMA(series, order)

26. Market Risk Analysis Formulas:

27. Beta Coefficient:Usage: Measures the sensitivity of an asset's returns to changes in the
market returns.Example: Beta = Covariance(R_asset, R_market) / Variance(R_market)

28. Value at Risk (VaR):Usage: Estimates the maximum potential loss of an investment within a
given confidence level.Example: VaR = Z * Std Deviation * Portfolio Value

29. Portfolio Management Formulas:

30. Sharpe Ratio:Usage: Measures the risk-adjusted return of a portfolio.Example: Sharpe

Ratio = (Portfolio Return - Risk-Free Rate) / Portfolio Standard Deviation

31. Treynor Ratio:Usage: Measures the excess return per unit of systematic
risk.Example: Treynor Ratio = (Portfolio Return - Risk-Free Rate) / Beta

Module 4: Application of Data Science across Financial Services: Learn about Financial Data
Analytics with respect to Data Science in Financial Services, Artificial Intelligence and Machine
Learning in Financial Services, Usage of AI in Algorithmic Stock Trading, Automated Robo-Advisors,
Fraud Detection and Prevention

Q1. What are the applications of data science in finance?

A. Data science can be used to optimize investment portfolios based on historical data and
market trends. By leveraging these insights from big data and advanced analytics, portfolio
managers can be empowered to identify potential risk factors, choose the optimal mix of
assets, and predict future movements in the market.
What is Machine Learning (in Finance)?

A. Machine learning in finance is now considered a key aspect of several financial services
and applications, including managing assets, evaluating levels of risk, calculating credit
scores, and even approving loans. Machine learning is a subset of data science that
provides the ability to learn and improve from experience without being programmed.

As an application of artificial intelligence, machine learning focuses on developing systems that

can access pools of data, and the system automatically adjusts its parameters to improve
experiences. Computer systems run operations in the background and produce outcomes
automatically according to how it is trained.

Machine learning tends to be more accurate in drawing insights and making predictions when
large volumes of data are fed into the system. For example, the financial services industry
tends to encounter enormous volumes of data relating to daily transactions, bills, payments,
vendors, and customers, which are perfect for machine learning.

Nowadays, many leading fintech and financial services companies are incorporating machine
learning into their operations, resulting in a better-streamlined process, reduced risks, and
better-optimized portfolios.

How Machine Learning is Used in Finance

There are several ways in which machine learning and other tenets of artificial intelligence
(AI) are being employed in the finance industry. Some of the applications of machine learning
in finance include:

Algorithmic trading
Algorithmic trading refers to the use of algorithms to make better trade decisions. Usually,
traders build mathematical models that monitor business news and trade activities in real-
time to detect any factors that can force security prices to rise or fall. The model comes with a
predetermined set of instructions on various parameters – such as timing, price, quantity, and
other factors – for placing trades without the trader’s active involvement.

Unlike human traders, algorithmic trading can simultaneously analyze large volumes of data
and make thousands of trades every day. Machine learning makes fast trading decisions, which
gives human traders an advantage over the market average.

Also, algorithmic trading does not make trading decisions based on emotions, which is a
common limitation among human traders whose judgment may be affected by emotions or
personal aspirations. The trading method is mostly employed by hedge fund managers and
financial institutions to automate trading activities.

Fraud detection and prevention

Fraud is a major problem for banking institutions and financial services companies, and it
accounts for billions of dollars in losses each year. Usually, finance companies keep a large
amount of their data stored online, and it increases the risk of a security breach. With
increasing technological advancement, fraud in the financial industry is now considered a high
threat to valuable data.

Fraud detection systems in the past were designed based on a set of rules, which could be
easily bypassed by modern fraudsters. Therefore, most companies today leverage machine
learning to flag and combat fraudulent financial transactions. Machine learning works by
scanning through large data sets to detect unique activities or anomalies and flags them for
further investigation by security teams.

It works by comparing a transaction against other data points – such as the customer’s account
history, IP address, location, etc. – to determine whether the flagged transaction is parallel to
the behavior of the account holder. Then, depending on the nature of a transaction, the system
can automatically decline a withdrawal or purchase until a human makes a decision.

Portfolio management (Robo-advisors)

Robo-advisors are online applications that are built using machine learning, and they provide
automated financial advice to investors. The applications use algorithms to establish a financial
portfolio according to an investor’s goals and their risk tolerance.

Robo-advisors require low account minimums and are usually cheaper than human portfolio
managers. When using robo-advisors, investors are required to enter their investment or
savings goal into the system, and the system will automatically determine the best investment
opportunities with the highest returns.

For example, an investor who is 30 years of age with a savings goal of $500,000 by the time
they retire can enter these goals into the application. The application then spreads the
investments across different financial instruments and asset classes – such as stocks, bonds,
real estate, etc. – to achieve the investor’s long-term goals. The application optimizes the
investor’s goals according to real-time market trends to find the best diversification strategy.

Loan underwriting
In the banking and insurance industry, companies access millions of consumer data, with
which machine learning can be trained in order to simplify the underwriting process. Machine
learning algorithms can make quick decisions on underwriting and credit scoring and save
companies both time and financial resources that are used by humans.

Data scientists can train algorithms on how to analyze millions of consumer data to match data
records, look for unique exceptions, and make a decision on whether a consumer qualifies for
a loan or insurance.

For example, the algorithm can be trained on how to analyze consumer data, such as age,
income, occupation, and the consumer’s credit behavior – history of default, if they paid on
loans, history of foreclosures, etc. – so that it can detect any outcomes that might determine if
the consumer qualifies for a loan or insurance policy.

Q. How is Data Science used in Finance? Benefits & Applications

A. The finance industry deals with significant volumes of highly sensitive data. This sector is
heavily regulated and is also a frequent target of fraud, so it’s vital to have the right data
processes and tools in place.

Data science is a powerful way for organizations in the financial industry to optimize
operations, empower decision-makers, and manage risks.

Data science uses statistics, advanced analytics, artificial intelligence (AI), machine learning
(ML), and specialized programming to extract meaningful insights from data to drive strategic
planning and empower decision-making.

Data science is widely used in the finance industry to improve decision-making, reduce risk,
and increase efficiency. Leveraging data scientists is a growing part of finance organizations’
strategy, helping to build data pipelines, implement machine learning models, and create
visualizations and reports to communicate insights from the vast amounts of data that these
organizations have access to.

7 Benefits of Data Science in the Finance Industry

The top benefits financial institutions can realize from using data science are:

1. Fraud detection and prevention

2. Credit allocation

3. Risk management and analysis

4. Customer analytics and segmentation

5. Algorithmic trading

6. Portfolio optimization

7. Pricing optimization

Fraud detection and prevention

Fraud in the financial industry can include identity theft, creating a fake bank account, applying
for a loan under a false name, direct theft of funds, money laundering, attempted tax evasion,
and speculatory trading.
Because the financial world, and the efforts to take advantage of it, move in real-time, your
organization’s fraud detection must move in real-time, too.

Machine learning systems create algorithms that process incredibly large datasets with
numerous variables to identify correlations between user behavior and the likelihood of
fraudulent actions.

This enables your organization to detect and address risks more quickly and accurately.

Credit allocation

Nearly everyone today has a digital footprint, a unique trail of traceable data you leave when
using the internet or digital devices.

This data, including one’s digital activities, contributions, communications, and actions, can be
examined by machine learning algorithms to reveal relationships between factors and
customer behavior.

This can, in turn, affect credit allocation by predicting how likely an individual is to pay back a
loan.

Risk management and analysis

To analyze creditworthiness, financial institutions can leverage machine learning algorithms to

analyze customers’ transactions, histories, and behaviors.

This information can be used to assess the likelihood of a borrower defaulting on a loan, which
can help organizations make strategic decisions to manage risk and increase security.

Customer analytics and segmentation

Today, 73% of customers expect the companies they interact with to understand their unique
needs, desires, and expectations. Data science provides financial institutions with powerful
insights into customer behavior.

These real-time analytics can empower your organization to segment customers based on their
behaviors and spending patterns to ultimately provide the personalized services and offerings
that they need and expect. This personalization, in turn, drives greater customer satisfaction
and customer loyalty.

Algorithmic trading

Algorithmic trading is a process of executing orders using automated, pre-programmed trading

instructions to account for variables including volume, time, and price.

It can channel massive amounts of data into streamlined insights, enabling financial
institutions to make more accurate and effective predictions about financial markets.

Portfolio optimization

Data science can be used to optimize investment portfolios based on historical data and
market trends.

By leveraging these insights from big data and advanced analytics, portfolio managers can be
empowered to identify potential risk factors, choose the optimal mix of assets, and predict
future movements in the market.
Pricing optimization

Financial institutions can leverage data analysis and machine learning to parse and assess
competitor pricing and market demand, enabling them to optimize prices for their products
and services.

Risks & Considerations When Utilizing Data Science Models

The benefits of data science can be significant for the finance industry, but if implemented
improperly, or by those without enough experience of the potential risk, there can be
significant negative consequences.

These risks include:

• Bias in data and algorithms: The data used for analysis and algorithms that organizations
then use for decision-making can be biased, leading to inaccurate insights and results.

• Privacy concerns: The use of personal data for analysis and decision-making raises
concerns about privacy and data security.

• Model risk: Predictive models used for decision-making can be unreliable, leading to
incorrect predictions and decision-making errors.

• Lack of transparency: Automated decision-making systems may lack transparency, making

it difficult to understand how decisions are made and to challenge them.

• Regulatory compliance: The use of data science in finance must comply with relevant
regulations and laws, including data protection and privacy laws.

• Technical failures: Technical failures, such as system failures and data breaches, can have a
significant impact on the reliability and accuracy of data-driven decisions.

• Economic risks: The use of data science in finance can lead to economic risks, including the
possibility of losses due to incorrect predictions or investments.

It is important for organizations to address these risks and to implement measures to mitigate
them, such as regular audits, model validation, and data governance programs. This can help
to ensure that data science is used in a responsible and effective manner.

Q. What is the role of data science in artificial intelligence?

A. “AI is an algorithm that relies heavily on data; if there is enough good-quality data, the AI
will run successfully. Data science offers the techniques, means, and approaches used to
extract data from the available sources and ensure that it will help train AI models.

Q. How To Use Artificial Intelligence To Invest

Artificial intelligence (AI), once the stuff of science fiction, is now making million-dollar
investing decisions in milliseconds. In 2024, individual investors are left wondering: Is AI the
key to unlocking unprecedented returns, or is it a double-edged sword that could reshape the
financial landscape in unpredictable ways?

Integrating AI into investment portfolios is no longer reserved for tech giants and hedge funds.
However, from stock selection algorithms to machine learning models that predict market
trends, AI tools have become far more available to retail investors. These technologies can
process vast amounts of data, help allocate portfolios, manage risk, and even provide
personalized investment advice. Yet, as these AI applications proliferate, so do the questions
surrounding how well they work and their long-term impact on the market.

Here are some of the ways retail investors are using AI in their portfolios.

Stock Picking With AI

Investors have an overwhelming amount of data on all stocks traded on U.S. markets, which
they examine to decide whether specific shares are worth buying or selling. AI potentially
allows you to sort through this data to identify stocks that meet their criteria.

AI-Automated Portfolios

Robo-advisors like Wealthfront and Betterment automate the traditional process of working
with an advisor to outline investing goals, time horizons, and risk tolerances to create a
portfolio. Automated portfolios guide you through a questionnaire that then scores to a model
portfolio that meets the criteria of the investor.

In addition to the questionnaire and the scoring of models, these platforms also use AI to
determine the best mix of individual stocks for your portfolio. Automated portfolios can also
be set to rebalance automatically should the target allocations in the portfolio drift too far
from your original selections.

Portfolio Optimization

AI is a good tool for improving a portfolio, allowing you to identify a portfolio that fits your
specific needs, including your risk tolerance and time horizon. In addition, once you select a
particular type of portfolio, a platform's AI can be used with modern portfolio theory to choose
stocks and other assets that fall on the efficient frontier. This is a set of optimal portfolios that
offer the highest expected return for a preset level of risk.4

Below are other uses for AI in constructing a portfolio:

Uses of AI for Your Portfolio

Table with 3 columns and 12 rows. Sorted ascending by column "AI Applications"

Application in Portfolio
AI Applications Optimization Benefits

Execute trades efficiently

Saves money on trading
Algorithmic Trading based on portfolio
costs
decisions

Spreads your risk more

Groups similar
Clustering Algorithms effectively;
investments together
diversification
Table with 3 columns and 12 rows. Sorted ascending by column "AI Applications"

Application in Portfolio
AI Applications Optimization Benefits

Considers practical limits

Constraint Handling Ensures your portfolio is
like minimum investment
Algorithms actually doable
amounts

Finds portfolio mixes

Tries out thousands of
Genetic Algorithms you might not have
investment combinations
thought of

High-Frequency Data Tracks price changes Keeps your portfolio

Analysis throughout the day balanced more precisely

Predict asset returns and Helps you choose

Machine Learning
risks investments more wisely

Helps you understand

Assess portfolio risk under
Monte Carlo Simulations and manage your
various scenarios
investment risks

Balances multiple goals

Multi-Objective More nuanced portfolio
(e.g., risk vs. return, short-
Optimization construction
and long-term aims)

Keeps your investments

Analyze news and social
Natural Language Processing in tune with current
media for sentiment
events, if you wish

Spots complex patterns in Better market insights

Neural Networks
market data for asset selection

Adjusts strategies as Keeps your portfolio up-

Reinforcement Learning
markets change to-date automatically

Helps predict how

Studies past market
Time Series Analysis investments might act in
behavior
the future

Managing Risk With AI

AI can optimize portfolios to lie on an efficient frontier, hopefully putting expected returns at
the level of risk you're willing to accept. These systems can also monitor and alert you when
you're overexposed to individual stocks or sectors.4 Here's a look at how AI can be used to
bolster classic ways of managing risk:

• Managing risks for specific trades: AI-powered tools can carry out complex order
strategies, such as conditional orders, stop-losses, and take-profit levels, to manage risk on
active trades. In addition, AI programs can design and automate options strategies for
hedging and income generation, adjusting these strategies in real time based on market
conditions.

• Sophisticated risk analysis: AI can run millions of simulations to assess portfolio risk under
various market scenarios, providing a more comprehensive view of potential outcomes. It
can also subject portfolios to stress tests, helping you understand how your investments
might perform during market crises.

• Dynamic risk adjustment: AI systems can continuously analyze market data, news, and
alternative data sources to detect risks early. Machine learning algorithms can adapt risk
models in real time, accounting for changing market dynamics and correlations.5

• Behavioral risk management: Algorithmic trading powered by AI can help reduce the
emotional aspect of trading. AI systems can implement preset rules, helping you stick to
your risk management strategies even in volatile markets.

• Regulatory compliance: AI can ensure that portfolios remain compliant with laws and
regulations, as well as your mandates, automatically flagging or adjusting for potential
violations.

• Tail risk management: AI models can attempt to identify potential extreme events that
traditional models might miss, helping prepare for tail risks, also known as "black swan"
events.

The percentage of American investors in a 2023 survey who said they would trust human
advice over that of AI.6

How Robo-Advisors Use Artificial Intelligence

Through automated portfolio building, robo-advisors automate the traditional process of

working with an advisor to outline investing goals, time horizons, and risk tolerances to create
a portfolio that meets the needs of the investor.

Automated portfolios guide the user through a questionnaire that then scores a model
portfolio that meets the investor's criteria. In addition to the questionnaire and the scoring of
models, these platforms also use AI to determine the best mix of individual stocks for the
portfolio, which is often accomplished using modern portfolio theory. Further, automated
portfolios are also set to automatically rebalance if the target allocations drift too far from the
selected portfolio.

Steps for Using Artificial Intelligence While Investing

If you want to incorporate AI into your investing or trading, you may consider taking the steps
that follow.

Step 1: Set Out Your Financial Goals

The first step is the same for every investor, which is to understand your financial goals so you
can move forward with an investment strategy that fits your needs.

Step 2: Choose Your Investing Method

Next, you need to determine whether you'll use a robo-advisor that does much of the work or
invest on your own. If you go with a robo-advisor, the advisor’s AI technology will do the heavy
lifting. You'll answer questionnaires, review model proposals, and give further input on
portfolio management.

Step 3: Select an Investing Strategy

If you're deciding on the investments, you'll need to determine your strategy to understand
the types of stocks you want. You can also use suggested models from robo-advisors, often
available for free, to help determine the mix of asset classes for their portfolio. This uses AI to
help set a strategy you'll manage individually.

Here are many of the major strategies investors use and how AI can help with them:

Step 4: Identify Your Investing Tools

Stock screeners are helpful AI tools when choosing individual stocks for your portfolio. These
often have preset filters to help you get started.

Step 5: Start Managing Your Portfolio

Once the portfolio is up and running, you can employ different automated tools to help
manage your positions to enter and exit your positions. You might also want to refine your
stock screen searches and learn to use the efficient frontier to craft a portfolio for favorable
returns and the lowest risk possible.

What Is Artificial Intelligence (AI)?

AI refers to using machines to simulate human intelligence. AI is performed by computers and

software and uses data analysis and rules-based algorithms. It can entail very sophisticated
applications and encompass an extensive range of applications.7 The tremendous amount of
data available on financial markets and financial market prices provides many prospects for
applying AI while trading.1

What Kind of Financial Data Is Analyzed by AI?

AI can analyze just about any financial information. This includes fundamental data, such as a
company’s earnings, cash flow, and any other data that may impact the stock’s price. AI is also
used in technical analysis, which incorporates data on the number of shares traded and other
mathematical criteria related to past prices.8

Is Investing With AI Suitable for Beginners?

Absolutely. Robo-advisors are often the first step for beginning investors, and these platforms
rely heavily on AI.2 While some AI represents the newest technology and the ability to
understand and process language, plenty of it is much more intuitive. AI allows investors to
filter stocks that meet their criteria much more simply through stock screeners.

Is Investing With AI Safe?

Investing with AI often is, but it's not without risks. AI-powered tools can provide more
sophisticated risk management, better diversification, and reduced emotional bias in decisions.
They can quickly process vast amounts of data, potentially identifying risks and prospects that
human analysts might miss. However, AI systems are often quite fallible. They can make errors
if fed inaccurate data or their algorithms are flawed. There's also the risk of overreliance on AI,
potentially leading to herd behavior if many investors use similar AI models. In addition, AI
systems may not fully account for unprecedented events or market conditions.

Therefore, while AI can significantly improve investment safety, it's crucial to use it as a tool to
augment, not replace, human judgment.

Module 5: Optimal Portfolio Allocation: Capital Allocation Line (CAL) and Optimal Portfolio,
Lending and Borrowing on the CAL, analysis using indifference curves. CAPM- Features of
Markowitz analysis, expected returns from historical averages, efficient frontier.

Capital Allocation Line (CAL) and Optimal Portfolio

The Capital Allocation Line (CAL) is a line that graphically depicts the risk-and-reward profile of
assets, and can be used to find the optimal portfolio. The process to construct the CAL for a
collection of portfolios is described below.

Portfolio expected return and variance

For the sake of simplicity, we will construct a portfolio with only two risky assets.

The portfolio’s expected return is a weighted average of its individual assets’ expected returns,
and is calculated as:

E(Rp) = w1E(R1) + w2E(R2)

Where w1, w2 are the respective weights for the two assets, and E(R 1), E(R2) are the respective
expected returns.

Levels of variance translate directly with levels of risk; higher variance means higher levels of
risk and vice versa. The variance of a portfolio is not just the weighted average of the variance
of individual assets but also depends on the covariance and correlation of the two assets. The
formula for portfolio variance is given as:

Var(Rp) = w21Var(R1) + w22Var(R2) + 2w1w2Cov(R1, R2)

Where Cov(R1, R2) represents the covariance of the two asset returns. Alternatively, the
formula can be written as:

σ2p = w21σ21 + w22σ22 + 2ρ(R1, R2) w1w2σ1σ2, using ρ(R1, R2), the correlation of R1 and R2.

The conversion between correlation and covariance is given as: ρ(R1, R2) = Cov(R1, R2)/ σ1σ2.

The variance of portfolio return is greater when the covariance of the two assets is positive,
and less when negative. Since variance represents risk, the portfolio risk is lower when its
asset components possess negative covariance. Diversification is a technique that minimizes
portfolio risk by investing in assets with negative covariance.
In practice, we do not know the returns and standard deviations of individual assets, but we
can estimate these values based on these assets’ historical values.

The efficient frontier

A portfolio frontier is a graph that maps out all possible portfolios with different asset weight
combinations, with levels of portfolio standard deviation graphed on the x-axis and portfolio
expected return on the y-axis.

Optimal portfolio

The optimal portfolio consists of a risk-free asset and an optimal risky asset portfolio. The
optimal risky asset portfolio is at the point where the CAL is tangent to the efficient frontier.
This portfolio is optimal because the slope of CAL is the highest, which means we achieve the
highest returns per additional unit of risk. The graph below illustrates this:

What is the Cal portfolio theory?

The Capital Allocation Line (CAL) represents the risk and return trade-off for a portfolio that
combines the risk-free asset and risky assets. It aims to help investors assess their risk profile
and it illustrates the level of potential returns that can be expected for the different levels of
risk.
 What is the difference between capital allocation line (CAL) and capital market line (CML)?

The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolios
for an investor. CML is a special case of the CAL where the risk portfolio is the market portfolio.
As an investor moves up the CML, the overall portfolio risk and returns increase.

What is the optimal portfolio for CFA?

The optimal portfolio for each investor is the highest indifference curve that is tangent to the
efficient frontier. This is portfolio selection with a risk-free asset: The optimal portfolio for each
investor is the highest indifference curve that is tangent to the capital allocation line.

What is the relationship between portfolio theory and CAPM?

The CAPM uses the principles of modern portfolio theory to determine if a security is fairly
valued. It relies on assumptions about investor behaviors, risk and return distributions, and
market fundamentals that don't match reality.

What is the Markowitz portfolio theory?

Instead of focusing on the risk of each individual asset, Markowitz demonstrated that a
diversified portfolio is less volatile than the total sum of its individual parts. While each asset
itself might be quite volatile, the volatility of the entire portfolio can actually be quite low.

What is Markowitz capital market theory?

Markowitz defines the efficient frontier as the highest expected return for a given level of risk,
or the lowest risk for a given expected return. The efficient frontier illustrates the trade-offs
between risk and return, helping investors identify portfolios that align with their risk
tolerance and investment goals.

What are the assumptions of Markowitz portfolio theory?

The theory assumes markets are efficient, investors are risk-averse and want maximum
returns, and greater returns come with greater risk. Diversification aims to reduce risk by
lowering standard deviation and covariance between securities.

Module 6: Risk-Return Trade-off & Quadratic Utility: Investments and trade consumption across time,
trade-off between risk and return, decision making under uncertainty, indifference curves, quadratic
utility function, etc.

What is the risk-return trade-off theory?

Risk-return tradeoff states that the potential return rises with an increase in risk. Using this
principle, individuals associate low levels of uncertainty with low potential returns, and high
levels of uncertainty or risk with high potential returns.

What is the trade-off between risk and return graph?

The risk curve is a visual depiction of the tradeoff between risk and return among investments.
The curve denotes that lower-risk investments, plotted to the left, will carry lesser expected
return; those riskier investments, plotted to the right, will have a greater expected return.

A quadratic utility function is widely applied in economic and finance theory. The main
advantage of a quadratic utility function is its tractability, and this is the main reason why the
quadratic function is applied as an objective function for various optimization problems in
economics and finance.

What is a quadratic utility function?

The quadratic utility function is based on the idea that investors don't like risk and prefer more
wealth to less. It assumes normal return distributions and quadratic preferences, which help
simplify investment decisions. This makes it easier to use math to get precise financial models.

Understanding the Quadratic Utility Function

The quadratic utility function is key in utility maximization models. It balances risk and return
well, making it fundamental in financial modeling. It looks at both the average and the spread
of investment returns. This provides a full picture that helps in making portfolios better.

Investors’ choices are shaped by their unique risk and return preferences. Understanding these
preferences is crucial for using utility maximization models to improve financial outcomes. By
considering how much risk an investor can handle, financial experts can make better
investment plans.

The core idea of the quadratic utility function is that extra wealth brings less happiness over
time. This concept is very important in modern financial modeling. Next, a table compares the
quadratic utility function to other types, showing what makes it special:

Quadratic Utility Linear Utility Exponential Utility

Characteristic
Function Function Function

Considers both Considers only Considers risk

Risk Assessment
mean and variance mean aversion parameter

Investor Incorporates risk High sensitivity to

Risk-neutral
Preference aversion risk

Complexity in
Moderate Low High
Calculation

Basic
Portfolio Insurance and high-
Application investment
optimization risk investments
analysis

In the end, learning about the detailed features of the quadratic utility function improves our
understanding of utility models. It also betters our use of financial modeling techniques.