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Finance is the process of channeling money from savers and investors to entities that need it. Savers and investors have money available which could earn interest or dividends if put to productive use. Individuals, companies and governments must obtain money from some external source, such as loans or credit, when they lack sufficient funds to operate. Finance deals with 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.
In academia, finance refers to the study of the securities and derivatives markets, and the institutions that serve as intermediaries to those markets and enable the flow of money through the economy. It is also the study of how to determine the value of assets such as stocks, bonds, loans, and by extension entire companies. Accurately determining value is crucial to sound business decisions. In some cases, such as one company acquiring another or entering a new line of business, judgements about asset values can make or break the investor.
The following are definitions of finance as crafted by the authors indicated:
- F.W.Paish: "Finance may be defined as the position of money at the time it is wanted".
- John J. Hampton: "The term finance can be defined as the management of the flows of money through an organisation, whether it will be a corporation, school, or bank or government agency".
- Howard and Upton: "Finance may be defined as that administrative area or set of administrative functions in an organisation which relates with the arrangement of each debt and credit so that the organisation may have the means to carry out the objectives as satisfactorily as possible".
- financial services;
- investment management, securities trading and stock brokerage;
- investment banking;
- financial engineering; and
- risk management.
Given its wide scope, finance is studied in several academic disciplines, and there are several related professional qualifications that lead to the field.
History of finance
The origin of finance can be traced to the start of civilization. The earliest historical evidence of finance is dated back from 3000 BC. Banking originated in the Babylonian empire, where temples and palaces were used as safe places for the storage of valuables. Initially, the only valuable that could be deposited was grain, but cattle and precious materials were eventually included. During the same time period, the Sumerian city of Uruk in Mesopotamia supported trade by lending as well as the use of interest. In Sumerian, “interest” was mas, which translates to "calf". In Greece and Egypt, the words used for interest, tokos and ms respectively, meant “to give birth”. In these cultures, interest indicated a valuable increase, and seemed to consider it from the lender’s point of view. During the Reign of Hammurabi (1792-1750 BC) in Babylon, the Code of Hammurabi included laws governing banking operations. The Babylonians were accustomed to charge interest at the rate of 20 per cent per annum.
In the Biblical world point of view within the Jewish Civilization (1500 BC), Jews were not allowed to take interest from other Jews, but they were allowed to take interest from the gentiles. The reason for the non-prohibition of the receipt by a Jew of interest from a Gentile, and vice versa, is held by modern rabbis to lay in the fact that the Gentiles had at that time no law forbidding them to practice usury. As they took interest from Jews, the Torah considered it equitable that Jews should take interest from Gentiles. In Hebrew, interest is neshek. As opposed to other ancient civilizations, interest is considered from borrower's point of view.
By 1200 BC, Cowrie shells were used as a form of money in China, and by 640 BC, the Lydians had started to use coin money. Lydia was the first place where permanent retail shops opened. (Herodotus mentions the use of crude coins in Lydia in an earlier date, i.e. 687 BC.)
In 500 BC, Pythius became the first banker that had records, and operated in both Western Anatolia and Greece. The use of coins as a means of representing money began in the years between (600-570 BC). Cities under the Greek empire, such as Aegina (595 B.C.), Athens (575 B.C.) and Corinth (570 B.C.), started to mint their own coins. Leading thinkers and statesmen, such as Cato the Elder, Cato the Younger, Cicero, and Plutarch were against usury. In the Roman Republic, interest was outlawed altogether by the Lex Genucia reforms. Under the banner of Julius Caesar, a ceiling on interest rates of 12% was set, and later under Justinian, it was lowered even further to between 4% and 8%.
The financial system
The financial system consists of the flows of capital that take place 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.
In general, 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 government 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 funds – 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. 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. The investment banks find the initial investors and facilitate the listing of the securities, such as equity and debt. Additionally, they facilitate 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 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, investing, and saving for retirement. Personal finance may also involve paying for a loan or other debt obligations. The main areas of personal finance are considered to be income, spending, saving, investing, and protection. 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, subsidies, or penalties on the management of personal finances;
- Understanding the effects of credit on individual financial standing;
- Developing 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 or other 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. 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. It generically entails three primary areas of capital resource allocation:
- Capital budgeting: selecting which projects to invest in;
- Dividend policy: the use of "excess" capital;
- Sources of capital: which funding is to be used.
While 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. 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. In this context, Financial risk management is about protecting the firm's economic value by using financial instruments to manage exposure to risk, particularly credit risk and market risk, often arising from the firm's funding structures.
Public finance describes finance as related to sovereign states, sub-national entities, and related public entities or agencies. It generally encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods typically 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, or 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. They act as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.
Financial theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics. Abstractly, finance is concerned with the investment and deployment of assets and liabilities over "space and time"; it is about performing valuation and asset allocation today, based on risk and uncertainty of future outcomes while incorporating the time value of money. It includes 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, there have been recent efforts to organize a list of unsolved problems in finance.
Financial economics is the branch of economics that studies 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 centers on pricing and managing risk management in the financial markets, and thus produces many commonly employed financial models.
It is a field that 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" (see Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence contributes to corporate finance theory. Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
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 overlaps heavily with the field of computational finance, also known as financial engineering. While these are largely synonymous, the latter focuses on application, and the former focuses on modeling and derivation (see: Quantitative analyst). There is also a significant overlap with financial risk management.
Experimental finance aims to establish different market settings and environments to experimentally observe 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, as well as 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 of people in artificial competitive market-like settings.
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets, and is relevant 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 an integral aspect of 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.
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growth of behavioral finance.
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