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Applying Data Science in Finance

By: Kaplan Schweser
April 12, 2021

Financial data science is the application of data science techniques to issues of finance. 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.

Read on to learn more about financial data science, how to apply it, and where it is used.

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. But what is it? What do you need to know for financial data science? 

What is Financial Data Science?

The field of financial analysis use 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, predictive and prescriptive analytics to provide robust possibilities for understanding financial data and solving related problems. The field is growing by leaps and bounds. 

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 Apply Data Science in Finance

Data science can be applied to finance in a number of 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 weakness 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 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. 

Credit Allocation

Every person who accesses or registers on a website leaves a trail of information called a digital footprint, an extremely large 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.

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:

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 already 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.

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.

All the major financial institutions are hiring financial data scientists. If you are interested in a financial data scientist role, set yourself apart by earning the Financial Data Professional Charter® and signing up for an in-depth review before you take the exam.