Principles of Financial Modelling

CHAPTER 10Dealing with Circularity

INTRODUCTION

This chapter discusses the issue of dealing with circularities. We make a distinction between circularities that arise as an inherent property of the real-life situation and those resulting from the presence of circular formulae within an implemented model (also called circular references). We discuss the potential advantages and disadvantages of using circular formulae, ways to deal with circular logic and methods to (where desired) retain the inherent circularity in the logic of a real-life situation whilst avoiding any circular formulae in the model.

THE DRIVERS AND NATURE OF CIRCULARITIES

This section discusses the fundamental distinction between circularities that are an inherent property of the real-life situation and those resulting from the way that formulae are implemented in Excel.

Circular (Equilibrium or Self-regulating) Inherent Logic

Many real-life situations can be described using mathematical equations. Often, such equations express some form of equilibrium or self-regulation within a system. For example, the heat generated by a thermostatically controlled radiator depends on the difference between the current room temperature and the target level. At the same time, the room temperature will be affected by (depend on) the new heat generated by the radiator. Similarly, in economics, “circular” logic may arise as a statement of some form of equilibrium within the system being modelled, characterised by the presence ...