Finance

Finance is a term for matters regarding the management, creation, and study of money and investments.[1] Specifically, it deals with the questions of how and why an individual, company or government acquires the money needed – called capital in the company context – and how they spend or invest that money. [2] Finance is then often split per the following major categories: corporate finance, personal finance and public finance.[1]

For the board game, see Finance (game).
"Financial" redirects here. For the Caucasian newspaper, see The Financial.
Finance

At the same time, and correspondingly, finance is about the overall "system" [1]  – 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 and stock broking, investment banking, financial engineering, and risk management.

Given its wide scope, finance is studied in several academic disciplines, and, correspondingly, there are several related professional qualifications that can lead to the field.

The financial system
Main articles: Financial services, financial market, and Circular flow of income

As above, the financial system constitutes the flow of capital, between individuals (personal finance), governments (public finance), and businesses (corporate finance). 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.

Generalizing, an entity whose income exceeds its expenditure can lend or invest the excess, intending to earn a fair return. Correspondingly, an entity where income is less than expenditure can raise capital usually in one of two ways: (i) by borrowing, in the form of a loan (private individuals), or by selling bonds (may be government bonds or corporate bonds); (ii) by a corporate selling equity, also called stock or shares (may take various forms: preferred stock or common stock). The owners of both bonds and stock may be institutional investors – financial institutions such as investment banks and pension fund – or private individuals, called private investors or retail investors.

The lending is often indirect, through a financial intermediary such as a bank, or via the purchase of 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.[3][4][5] 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.

Investing typically entails the purchase of stock, either individual securities, or via a mutual fund for example. Stocks are usually sold by corporations to investors so as to raise required capital in the form of "equity financing", as distinct from the debt financing described above. The financial intermediaries here are the investment banks, which find the initial investors and facilitate the listing of the securities (equity and debt); and the securities exchanges, which allow their trade thereafter, as well as the various service providers which manage the performance or risk of these investments.

Areas of finance

Personal finance
Main article: Personal finance

Personal finance[6] 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.[7] Personal finance may also involve paying for a loan, or debt obligations. The main areas of personal finance are considered to be income, spending, saving, investing, and protection.[8] The following steps, as outlined by the Financial Planning Standards Board[9], 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[10]

Corporate finance
Main article: Corporate finance

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. 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: (i) "capital budgeting", selecting which projects to invest in; (ii) dividend policy, the use of "excess" capital; and (iii) "sources of capital", i.e. which funding is to be used. The latter creates the link with investment banking and securities trading, in that the capital raised will (generically) comprise debt, i.e. corporate bonds, and equity, often listed shares.

Although "corporate finance" 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. Further, although financial management overlaps with the financial function of the accounting profession, financial accounting is the reporting of historical financial information, whereas as discussed, financial management is concerned with increasing the firm's Shareholder value and increasing their rate of return on the investment. Financial risk management, in this context, is about protecting the firm's economic value using financial instruments to manage exposure to risk, particularly credit risk and market risk, often arising from the firm's funding structures.

Public finance
Main article: Public finance

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.[11] These long-term strategic periods usually encompass five or more years.[12] 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.[13]

Financial theory

Finance theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics. Abstractly,[2] 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). Since the debate to whether finance is an art or a science is still open,[14] there have been recent efforts to organize a list of unsolved problems in finance.

Financial economics
Main article: Financial economics

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 pricing and managing risk management in the financial markets, and thus produces many of the and financial models commonly employed.

The discipline essentially explores how rational investors would apply risk and return to the problem of investment. 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", 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.

Financial mathematics

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.

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 and Outline of finance #Derivatives pricing.

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). There is also a significant overlap with financial risk management.

Experimental finance
Main article: Experimental finance

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
Main article: Behavioral economics

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.[15]

Behavioral finance includes such topics as:

  1. Empirical studies that demonstrate significant deviations from classical theories.
  2. Models of how psychology affects and impacts trading and prices
  3. Forecasting based on these methods.
  4. 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.

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See also

References
  1. Staff, Investopedia (2003-11-20). "Finance". Investopedia. Retrieved 2018-11-26.
  2. "Finance" Farlex Financial Dictionary. 2012
  3. Bank of Finland. "Financial system".
  4. "Introducing the Financial System | Boundless Economics". courses.lumenlearning.com. Retrieved 2020-05-18.
  5. "What is the financial system?". Economy.
  6. "Personal Finance - Definition, Overview, Guide to Financial Planning". Corporate Finance Institute. Retrieved 2019-10-23.
  7. Publishing, Speedy (2015-05-25). Finance (Speedy Study Guides). Speedy Publishing LLC. ISBN 978-1-68185-667-4.
  8. "Personal Finance - Definition, Overview, Guide to Financial Planning". Corporate Finance Institute. Retrieved 2020-05-18.
  9. "Financial Planning Standards Board", Financial Planning Competency Handbook, John Wiley & Sons, Ltd, 2019, pp. 709–735, doi:10.1002/9781119642497.ch80, ISBN 9781119642497
  10. Kenton, Will. "Personal Finance". Investopedia. Retrieved 2020-01-20.
  11. Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. p. 23. ISBN 978-1439892237.
  12. Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. pp. 53–54. ISBN 978-1439892237.
  13. Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov Accessed: 2010-01-16. (Archived by WebCite at Archived 2010-01-14 at the Wayback Machine)
  14. "Is finance an art or a science?". Investopedia. Retrieved 2015-11-11.
  15. Shefrin, Hersh (2002). Beyond greed and fear: Understanding behavioral finance and the psychology of investing. New York: Oxford University Press. p. ix. ISBN 978-0195304213. Retrieved 8 May 2017. growth of behavioral finance.
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