Table of Contents
Academic discipline studying businesses and investments
Finance is the study of money and how it is used. Specifically, it deals with the questions of how an individual, company or government acquires the money needed – called capital in the company context – and how they then spend or invest that money.
Core financial theories can largely be divided into the following categories: financial economics, mathematical finance and valuation.
In the context of institutions, finance is often split into the following major categories: investment management, corporate finance, personal finance and public finance.
At the same time, finance is about the overall “system”
– i.e. the financial markets that allow the flow of money, via investments and other financial instruments, between and within these areas;
this “flow” is facilitated by the financial services sector.
A major focus within finance is thus investment management — called money management for individuals, and asset management for institutions — and finance then includes the associated activities of securities trading & stock broking, investment banking, financial engineering, and risk management.
More abstractly, finance is concerned with the investment and deployment of assets and liabilities over “space and time”:
i.e. it is about performing valuation and asset allocation today,
based on risk and uncertainty of future outcomes,
incorporating the time value of money (determining the present value of these future values, “discounting”, requires a risk-appropriate discount rate).
As an academic field, finance theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics.
Correspondingly, given its wide application, there are several related professional qualifications, that can lead to the field.
As the debate to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance.
The financial system
An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though on the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower—a financial intermediary such as a bank—or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance), and by other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise. In corporate finance, a company’s capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales. Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share. Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.
Areas of finance
Personal finance is defined as the mindful planning of monetary spending and saving, while also considering the possibility of future risk.
Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal finance may also involve paying for a loan, or debt obligations.
The following steps, as outlined by the Financial Planning Standards Board, suggest that an individual will understand a potentially secure personal finance plan after:
- Purchasing insurance to ensure protection against unforeseen personal events
- Understanding the effects of tax policies (tax subsidies or penalties) management of personal finances
- Understanding the effects of credit on individual financial standing
- Developing of a savings plan or financing for large purchases (auto, education, home)
- Planning a secure financial future in an environment of economic instability
- Pursuing a checking and/or a savings account
- Preparing for retirement/ long term expenses
Corporate finance deals with the sources of funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. (Capital is of two types in the main, equity, and debt). Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Short term financial management is often termed “working capital management”, and relates to cash-, inventory- and debtors management.
In the longer term, corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity’s assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation.
- In the first, “capital budgeting”, management must choose which “projects” (if any) to undertake. The discipline of capital budgeting may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling.
- The second, “sources of capital” relates to how these investments are to be funded: investment capital can be provided through different sources, such as by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm’s operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance between these elements forms the company’s capital structure.
- The third, “the dividend policy”, requires management to determine whether any unappropriated profit (excess cash) is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so, in what form.
Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial instruments; in this sense it overlaps with financial engineering. Similar to general risk management, financial risk management requires identifying its sources, measuring it (see: Risk measure#Examples), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, whereas as discussed, financial management is concerned with the allocation of capital resources to increase a firm’s value to the shareholders and increase their rate of return on the investments.
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods usually encompass five or more years. Public finance is primarily concerned with:
- Identification of required expenditure of a public sector entity
- Source(s) of that entity’s revenue
- The budgeting process
- Debt issuance (municipal bonds) for public works projects
Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models.
It essentially explores how rational investors would apply risk and return to the problem of an investment policy. Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended.
“Financial economics”, at least formally, also considers investment under “certainty” (Fisher separation theorem, “theory of investment value”, Modigliani–Miller theorem) and hence also contributes to corporate finance theory.
Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Although they are closely related, the disciplines of economics and finance are distinct. The “economy” is a social institution that organizes a society’s production, distribution, and consumption of goods and services, all of which must be financed.
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The field is largely focused on the modelling of derivatives, although other important subfields include insurance mathematics and quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents’ behavior and the resulting characteristics of trading flows, information diffusion, and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future financial decisions. Research may proceed by conducting trading simulations or by establishing and studying the behavior, and the way that these people act or react, of people in artificial competitive market-like settings.
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance.
Behavioral finance includes such topics as:
- Empirical studies that demonstrate significant deviations from classical theories.
- Models of how psychology affects and impacts trading and prices
- Forecasting based on these methods.
- Studies of experimental asset markets and the use of models to forecast experiments.
A strand of behavioral finance has been dubbed quantitative behavioral finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001–2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm, and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.
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growth of behavioral finance.
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