Applying Data Science in Finance

Kaplan Schweser

Financial data science is the application of data science techniques to finance issues. Data science incorporates skills from computer science, mathematics, statistics, information visualization, graphic design, complex systems, communication, and business.

It relies on scientific methods and algorithms to extract insights from both structured and unstructured data. Its most common techniques incorporate predictive modeling, clustering, data wrangling, visualization, and dimensionality reduction.

What is Financial Data Science?
Knowledge Requirements
Applying Data Science
Data Science Examples
Using AI
How to Become a Financial Analyst

About Financial Data Science

Financial data science is changing how finance works and opening new doors for financial analysts willing to gain data science skills.

What is Financial Data Science?

The field of financial analysis uses statistical methods to understand the problems of finance. Financial data science combines the traditions of econometrics with the technological components of data science. Financial data science uses machine learning, and predictive and prescriptive analytics to provide robust possibilities for understanding financial data and solving related problems. The field is growing by leaps and bounds.

What is Financial Modeling? >>

Required Domain Knowledge

The combination of econometrics, data science, finance knowledge, and financial markets creates a long list of domains involved; these are the highlights:

Financial markets: Marketplaces where securities are traded, including the stock market, bond market, forex market, and derivatives market, among others.
Risk analytics: Using predictive modeling, forecasting, and scenario analysis to manage portfolio risk.
Quantitative methods: Statistical, mathematical, or numerical analyses of data from polls, surveys, or the manipulation of pre-existing statistical data computationally.
Hypothesis testing: A testable hypothesis is formed based on observed data and tested to determine whether an effect is statistically significant.
Linear regression: Using an (assumed) linear relationship to model relationships between two or more variables.
Volatility estimation: Estimation and modeling of the degree of variation of financial data series.
Time series analysis: Statistical techniques applied to sequences of numerical data points (from the same series) observed over time.
Simulation methods: Statistical methods that analyze the execution of a model that imitates the operation of a real-world process or system over time.
Valuation: Estimating the current (or projected) worth of an asset or a company.
Data wrangling: The cleaning, structuring and enriching of raw data into a desired format for analysis and modeling.
Machine learning models: Statistical models used to estimate real-world relationships, whose parameters are learned over time as more data become available.
Deep learning models: A subset of machine learning models including neural networks with more than two hidden layers.
Programming languages: SQL, Python, and R for data query, statistical computing, graphics, and more.

How To Become A Financial Analyst >>

How to Apply Data Science in Finance

Data science can be applied to finance in several ways, A few examples include fraud prevention, risk management, credit allocation, customer analytics, and algorithmic trading.

Fraud Prevention

Traditional fraud detection uses rule-based models that identify unusual transactions. These models often flag legal transactions based on broken rules or fraudulent activities when millions of transactions are happening at the same time.

By contrast, machine learning creates algorithms that process large datasets with many variables to find hidden correlations between user behavior and the likelihood of fraudulent actions.

Using machine learning techniques and big-data analytics, banks and other financial services firms create highly efficient systems to detect and prevent fraudulent activities including speculatory trading, rouge trading, and regulatory violations.

Risk Management

The 2008 financial crisis exposed weaknesses in traditional risk management tools and led to increased financial regulation and limits on risk-taking. Data science helps firms find better ways to measure and manage risk across the organization, using big-data analytics and machine learning to enable the incorporation of new unstructured data sources into real-time risk detection systems.

Credit and market risk exposures and valuations can be simulated more accurately, helping banks and financial firms to proactively monitor risks across the organization.

How to Become a Certified Financial Risk Manager >>

Credit Allocation

Every person who accesses or registers on a website leaves a trail of information called a digital footprint, a huge dataset that is packed with all kinds of useful information. Machine learning algorithms, supported by big data and high computational power, can parse digital footprints to unveil previously unknown relationships between new factors and customer behavior.

These insights can affect credit allocation and outperform traditional credit scoring models at predicting how likely a customer is to pay back a loan.

Customer Analytics

Many financial institutions have made customer experience and personalization a top priority. With the help of data science, they can gain insight into customer behavior as it is happening with the help of real-time analytics to make better strategic business decisions or offer consumers recommendations based on their banking or investing preferences.

For example, insurers are using supervised machine learning to understand drivers of consumer behavior, reduce losses by eliminating below-zero-value customers, increase cross-sale opportunities, and measure customers’ total lifetime value.

To understand customers, banks and financial firms also turn to unsupervised machine learning, where groups of similarly behaving customer groups can be identified using clustering techniques.

Algorithmic Trading

In algorithmic trading, complex mathematical formulas and high-speed computations help financial companies devise new trading strategies. Bigger i data in the form of growing and new data streams presents ongoing challenges for algorithmic trading models.

Such models measure and describe underlying data streams. An analytical engine makes market predictions by quickly incorporating and processing massive datasets. Another application involves using predictive machine learning techniques to determine the identity of market participants.

Accelerate your career with Kaplan Schweser’s Financial Modeling Course

Examples of Data Science in Finance

When data science is applied to finance, the combination helps build systems and processes to extract insights from financial data in various forms. It has significantly improved risk analysis and anomaly detection, leading to well-known improvements in the ability to detect fraudulent transactions and money laundering activities.

Here are some real-world examples of how financial services firms and banks are using financial data science.

Customer Service

In the field of customer service, forward-looking banks and fintechs serve their customers better by analyzing their transactional and behavioral data using various data science algorithms. Some of the world’s biggest banks are using data science to gain insights into previous customer purchases, engagements, and accounts that are most relevant to them.

Now they primarily receive notices about investment products, insurance coverage, bank accounts, mortgages, and other products that reflect their interests.

Financial Analyst Career Paths >>

Sales and Marketing

Data science is also delivering insights into how well a product sells or to whom it sells, so financial services firms and banks can develop consumer products, policies, and investment instruments that are likely to sell well in the future.

They can also use external data, such as market activities during a recession or what mortgage products sell best when the housing market is stagnant, to create products that are both useful to their customers and lucrative for the bank.

Using AI Language Models in Finance

Tools like ChatGPT and other similar AI language models have proven to be excellent administrative and analytical aids for finance professionals. It's important to learn how to effectively prompt Large Language Model programs for analysis purposes.

ChatGPT's Impact and the CFA® Program's Resilience >>

How to Become a Financial Analyst

If the idea of examining data trends and evaluating the performance of stocks and bonds to assist businesses or individuals in making informed investment decisions intrigues you, a profession as a financial analyst could be your ideal path.

Required Skills to Become a Financial Analyst >>