Finance is the study and discipline of
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
,
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
and
capital assets
A capital asset is defined as property of any kind held by an assessee, whether connected with their business or profession or not connected with their business or profession. It includes all kinds of property, movable or immovable, tangible or int ...
. It is related to, but not synonymous with
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
, the study of
production
Production may refer to:
Economics and business
* Production (economics)
* Production, the act of manufacturing goods
* Production, in the outline of industrial organization, the act of making products (goods and services)
* Production as a stati ...
,
distribution Distribution may refer to:
Mathematics
*Distribution (mathematics), generalized functions used to formulate solutions of partial differential equations
* Probability distribution, the probability of a particular value or value range of a vari ...
, and
consumption
Consumption may refer to:
*Resource consumption
*Tuberculosis, an infectious disease, historically
* Consumption (ecology), receipt of energy by consuming other organisms
* Consumption (economics), the purchasing of newly produced goods for curren ...
of money, assets,
goods and services
Goods are items that are usually (but not always) tangible, such as pens, physical books, salt, apples, and hats. Services are activities provided by other people, who include architects, suppliers, contractors, technologists, teachers, doctor ...
(the discipline of
financial economics
Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade".William F. Sharpe"Financial ...
bridges the two).
Finance activities take place in
financial systems
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of finan ...
at various scopes, thus the field can be roughly divided into
personal
Personal may refer to:
Aspects of persons' respective individualities
* Privacy
* Personality
* Personal, personal advertisement, variety of classified advertisement used to find romance or friendship
Companies
* Personal, Inc., a Washington, ...
,
corporate
A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and re ...
, and
public finance
Public finance is the study of the role of the government in the economy. It is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achie ...
.
In a financial system, assets are bought, sold, or traded as
financial instruments
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
, such as
currencies
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
,
loans
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
,
bonds,
shares
In financial markets, a share is a unit of equity ownership in the capital stock of a corporation, and can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Share capital refers to all of the shares of an ...
,
stocks
Stocks are feet restraining devices that were used as a form of corporal punishment and public humiliation. The use of stocks is seen as early as Ancient Greece, where they are described as being in use in Solon's law code. The law describing ...
,
options
Option or Options may refer to:
Computing
*Option key, a key on Apple computer keyboards
*Option type, a polymorphic data type in programming languages
* Command-line option, an optional parameter to a command
*OPTIONS, an HTTP request method
...
,
futures
Futures may mean:
Finance
*Futures contract, a tradable financial derivatives contract
*Futures exchange, a financial market where futures contracts are traded
* ''Futures'' (magazine), an American finance magazine
Music
* ''Futures'' (album), a ...
, etc. Assets can also be
banked,
invested, and
insured
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
to maximize value and minimize loss. In practice,
risks
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
are always present in any financial action and entities.
A broad range of subfields within finance exist due to its wide scope.
Asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
,
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
,
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
and
investment management
Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institut ...
aim to maximize value and minimize
volatility.
Financial analysis
Financial analysis (also known as financial statement analysis, accounting analysis, or analysis of finance) refers to an assessment of the viability, stability, and profitability of a business, sub-business or project.
It is performed by profes ...
is viability, stability, and profitability assessment of an action or entity. In some cases, theories in finance can be tested using the
scientific method
The scientific method is an empirical method for acquiring knowledge that has characterized the development of science since at least the 17th century (with notable practitioners in previous centuries; see the article history of scientific m ...
, covered by
experimental finance The goals of experimental finance are to understand human and market behavior in settings relevant to finance. Experiments are synthetic economic environments created by researchers specifically to answer research questions. This might involve, for ...
.
Some fields are multidisciplinary, such as
mathematical finance
Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets.
In general, there exist two separate branches of finance that require ...
,
financial law
Financial law is the law and regulation of the commercial banking, capital markets, insurance, derivatives and investment management sectors. Understanding financial law is crucial to appreciating the creation and formation of banking and financ ...
,
financial economics
Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade".William F. Sharpe"Financial ...
,
financial engineering
Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathema ...
and
financial technology
Fintech, a portmanteau of "financial technology", refers to firms using new technology to compete with traditional financial methods in the delivery of financial services. Artificial intelligence, blockchain, cloud computing, and big data are ...
. These fields are the foundation of
business
Business is the practice of making one's living or making money by producing or Trade, buying and selling Product (business), products (such as goods and Service (economics), services). It is also "any activity or enterprise entered into for pr ...
and
accounting
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...
.
The early history of finance parallels the early
history of money
The history of money concerns the development throughout time of systems that provide the functions of money. Such systems can be understood as means of trading wealth indirectly; not directly as with bartering. Money is a mechanism that facilit ...
, which is
prehistoric
Prehistory, also known as pre-literary history, is the period of human history between the use of the first stone tools by hominins 3.3 million years ago and the beginning of recorded history with the invention of writing systems. The use of ...
. Ancient and medieval civilizations incorporated basic functions of finance, such as banking, trading and accounting, into their economies. In the late 19th century, the
global financial system
The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financ ...
was formed.
It was in the middle of the 20th century that finance emerged as a distinct academic discipline, separate from economics. (The first academic journal, ''
The Journal of Finance
''The Journal of Finance'' is a peer-reviewed academic journal published by Wiley-Blackwell on behalf of the American Finance Association. It was established in 1946 and is considered to be one of the premier finance journals. The editor-in-chief i ...
'', began publication in 1946.) The earliest doctoral programs in finance were established in the 1960s and 1970s.
Finance is
widely studied at the undergraduate and masters level.
The financial system
![A1 Houston Office Oil Traders on Monday](https://upload.wikimedia.org/wikipedia/commons/f/f1/A1_Houston_Office_Oil_Traders_on_Monday.jpg)
As above, the financial system consists of the flows of capital that take place between individuals and households (
personal finance
Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.
When planning personal fi ...
), governments (
public finance
Public finance is the study of the role of the government in the economy. It is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achie ...
), and businesses (
corporate finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and anal ...
).
"Finance" thus studies 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.
In general, an entity whose income exceeds its
expenditure
An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition is a ...
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 corporation selling
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
, also called stock or shares (which may take various forms:
preferred stock
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt ins ...
or
common stock
Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Com ...
).
The owners of both bonds and stock may be ''
institutional investor
An institutional investor is an entity which pools money to purchase securities, real property, and other investment assets or originate loans. Institutional investors include commercial banks, central banks, credit unions, government-linked co ...
s'' financial institutions such as investment banks and
pension funds
A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides retirement income.
Pension funds typically have large amounts of money to invest and are the major investors in listed and priva ...
– or private individuals, called ''
private investors
An angel investor (also known as a business angel, informal investor, angel funder, private investor, or seed investor) is an individual who provides capital for a business or businesses start-up, usually in exchange for convertible debt or owners ...
'' or ''retail investors''.
The
lending
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
is often indirect, through a
financial intermediary
A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds ...
such as a
bank
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
, or via the purchase of notes or
bonds (
corporate bonds
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of ...
,
government bond
A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity date ...
s, or mutual bonds) in the
bond market
The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, b ...
.
The lender receives interest, the
borrower
A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...
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
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, either individual securities, or via a
mutual fund
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...
for example.
Stocks are usually sold by corporations to investors so as to raise required capital in the form of "
equity financing
In finance, equity is ownership of assets that may have debts or other Liability (financial accounting), liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For exampl ...
", as distinct from the ''debt financing'' described above.
The financial intermediaries here are the
investment bank
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing is ...
s. The investment banks
find the initial investors and facilitate the listing of the securities, typically shares and bonds.
Additionally, they facilitate the
securities exchange
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for the ...
s, which allow their trade thereafter, as well as the various service providers which manage the performance or risk of these investments.
These latter include
mutual funds
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...
,
pension funds
A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides retirement income.
Pension funds typically have large amounts of money to invest and are the major investors in listed and priva ...
,
wealth managers, and
stock brokers
A stockbroker is a regulated broker, broker-dealer, or registered investment adviser (in the United States) who may provide financial advisory and investment management services and execute transactions such as the purchase or sale of stocks and ...
, typically servicing
retail investors
An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...
(private individuals).
Inter-institutional trade and investment, and
fund-management at this scale, is referred to as "wholesale finance".
Institutions here
extend the products offered, with related trading, to include bespoke
options
Option or Options may refer to:
Computing
*Option key, a key on Apple computer keyboards
*Option type, a polymorphic data type in programming languages
* Command-line option, an optional parameter to a command
*OPTIONS, an HTTP request method
...
,
swaps, and
structured products
A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, an ...
, as well as
specialized financing; this "
financial engineering
Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathema ...
" is
inherently mathematical, and these institutions are then the major employers of
"quants" (see
below
Below may refer to:
*Earth
*Ground (disambiguation)
*Soil
*Floor
*Bottom (disambiguation)
Bottom may refer to:
Anatomy and sex
* Bottom (BDSM), the partner in a BDSM who takes the passive, receiving, or obedient role, to that of the top or ...
).
In these institutions,
risk management,
regulatory capital
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ad ...
, and
compliance
Compliance can mean:
Healthcare
* Compliance (medicine), a patient's (or doctor's) adherence to a recommended course of treatment
* Compliance (physiology), the tendency of a hollow organ to resist recoil toward its original dimensions (this is a ...
play major roles.
Areas of finance
As outlined, finance comprises, broadly, the three areas of personal finance, corporate finance, and public finance.
These, in turn, overlap and employ various activities and sub-disciplines chiefly
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
s, risk management, and
quantitative finance
Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets.
In general, there exist two separate branches of finance that require ...
.
Personal finance
![Wealth Management Consultation](https://upload.wikimedia.org/wikipedia/commons/0/00/Wealth_Management_Consultation.jpg)
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 good
In economics, a durable good or a hard good or consumer durable is a good that does not quickly wear out or, more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks could be consid ...
s such as
real estate
Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more general ...
and cars, buying
insurance
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
, investing, and saving for
retirement
Retirement is the withdrawal from one's position or occupation or from one's active working life. A person may also semi-retire by reducing work hours or workload.
Many people choose to retire when they are elderly or incapable of doing their j ...
.
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
Corporate finance deals with the actions that managers take to increase the value of the firm to the shareholders, the sources of funding and the
capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
of corporations, and the tools and analysis used to allocate financial resources.
While corporate finance is in principle different from managerial finance, which studies the
financial management
Financial management is the business function concerned with profitability, expenses, cash and credit, so that the "organization may have the means to carry out its objective as satisfactorily as possible;"
the latter often defined as maximizin ...
of all firms rather than corporations alone, the concepts are applicable to the financial problems of all firms,
[Pamela Drake and ]Frank Fabozzi
Frank J. Fabozzi is an American economist, educator, writer, and investor, currently Professor of Practice at The Johns Hopkins University Carey Business School and a Member of Edhec Risk Institute. He was previously a Professor of Finance at EDHE ...
(2009)
What Is Finance?
/ref>
and this area is then often referred to as "business finance".
Typically, then, "corporate finance" relates to the ''long term'' objective of maximizing the value of the entity's assets, its stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, and its return to shareholders, while also balancing risk and profitability. This entails three primary areas:
#Capital budgeting
Capital budgeting in corporate finance is the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development project ...
: selecting which projects to invest in here, accurately determining value is crucial, as judgements about asset values can be "make or break"
#Dividend policy Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's una ...
: the use of "excess" funds are these to be reinvested in the business or returned to shareholders
#Capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
: deciding on the mix of funding to be used here attempting to find the optimal capital mix re debt-commitments vs cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
The latter creates the link with investment banking
Investment banking pertains to certain activities of a financial services company or a corporate division that consist in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated wit ...
and securities trading
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
, as above, in that the capital raised will generically comprise debt, i.e. corporate bond
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of ...
s, and equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
, often listed shares.
Re risk management within corporates, see below
Below may refer to:
*Earth
*Ground (disambiguation)
*Soil
*Floor
*Bottom (disambiguation)
Bottom may refer to:
Anatomy and sex
* Bottom (BDSM), the partner in a BDSM who takes the passive, receiving, or obedient role, to that of the top or ...
.
Financial managers i.e. as distinct from corporate financiers focus more on the ''short term'' elements of profitability, cash flow, and "working capital management
Corporate finance is the area of finance that deals with the sources of funding, 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 allo ...
" (inventory
Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.
Inventory management is a discipline primarily about specifying the shap ...
, credit and debtor
A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...
s), ensuring that the firm can safely and profitably carry out its financial ''and operational'' objectives; i.e. that it:
(1) can service both maturing short-term debt repayments, and scheduled long-term debt payments ,
and (2) has sufficient cash flow for ongoing and upcoming operational expenses.
See and .
Public finance
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 expenditures of a public sector entity;
* Source(s) of that entity's revenue;
* The budgeting process;
* Sovereign debt issuance, or municipal bond
A municipal bond, commonly known as a muni, is a Bond (finance), bond issued by state or local governments, or entities they create such as authorities and special districts. In the United States, interest income received by holders of municipal ...
s for public works
Public works are a broad category of infrastructure projects, financed and constructed by the government, for recreational, employment, and health and safety uses in the greater community. They include public buildings ( municipal buildings, sc ...
projects.
Central banks, such as the Federal Reserve System
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
banks in the United States
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territorie ...
and the Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the English Government's banker, and still one of the bankers for the Government of ...
in the United Kingdom
The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the continental mainland. It comprises England, Scotland, Wales and North ...
, 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.
Development finance
A development financial institution (DFI), also known as a development bank or development finance company (DFC), is a financial institution that provides risk capital for economic development projects on a non-commercial basis.
, total commitme ...
, which is related, concerns investment in economic development
In the economics study of the public sector, economic and social development is the process by which the economic well-being and quality of life of a nation, region, local community, or an individual are improved according to targeted goals and o ...
projects provided by a (quasi) governmental institution on a non-commercial basis; these projects would otherwise not be able to get financing.
See .
A public–private partnership
A public–private partnership (PPP, 3P, or P3) is a long-term arrangement between a government and private sector institutions.Hodge, G. A and Greve, C. (2007), Public–Private Partnerships: An International Performance Review, Public Administ ...
is primarily used for infrastructure
Infrastructure is the set of facilities and systems that serve a country, city, or other area, and encompasses the services and facilities necessary for its economy, households and firms to function. Infrastructure is composed of public and priv ...
projects: a private sector corporate provides the financing up-front, and then draws profits from taxpayers and/or users.
Investment management
Investment management is the professional asset management of various securities typically shares and bonds, but also other assets, such as real estate, commodities and alternative investment
An alternative investment, also known as an alternative asset or alternative investment fund (AIF), is an investment in any asset class excluding stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as ...
s in order to meet specified investment goals for the benefit of investors.
As above, investors may be institutions, such as insurance companies, pension funds, corporations, charities, educational establishments, or private investors, either directly via investment contracts or, more commonly, via collective investment schemes like mutual funds, exchange-traded funds
An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the ...
, or REIT
A real estate investment trust (REIT) is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, including office and apartment buildings, warehouses, hospitals, shopping ce ...
s.
At the heart of investment management is asset allocation
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment tim ...
diversifying the exposure among these asset classes
In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having ...
, and among individual securities within each asset class as appropriate to the client's investment policy
An investment policy is any government regulation or law that encourages or discourages foreign investment in the local economy
Local purchasing is a preference to buy locally produced goods and services rather than those produced farther aw ...
, in turn, a function of risk profile, investment goals, and investment horizon (see Investor profile
An investor profile or style defines an individual's preferences in investment decisions, for example:
* Short-term trading (active management) or long term holding (buy and hold)
* Risk-averse or risk tolerant / seeker
* All classes of assets or ...
). Here:
*Portfolio optimization Portfolio optimization is the process of selecting the best portfolio (asset distribution), out of the set of all portfolios being considered, according to some objective. The objective typically maximizes factors such as expected return, and minimi ...
is the process of selecting the best portfolio given the client's objectives and constraints.
*Fundamental analysis
Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements (usually to analyze the business's assets, liabilities, and earnings); health; and competitors and markets. It also considers the overall state ...
is the approach typically applied in valuing and evaluating the individual securities.
Overlaid is the portfolio manager's investment style
Investment style refers to different style characteristics of equities, bonds or financial derivatives within a given investment philosophy.
Theory would favor a combination of big capitalization, passive and value. Of course one could almost get ...
broadly, active
Active may refer to:
Music
* ''Active'' (album), a 1992 album by Casiopea
* Active Records, a record label
Ships
* ''Active'' (ship), several commercial ships by that name
* HMS ''Active'', the name of various ships of the British Royal ...
vs passive
Passive may refer to:
* Passive voice, a grammatical voice common in many languages, see also Pseudopassive
* Passive language, a language from which an interpreter works
* Passivity (behavior), the condition of submitting to the influence of on ...
, value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...
vs growth
Growth may refer to:
Biology
* Auxology, the study of all aspects of human physical growth
* Bacterial growth
* Cell growth
* Growth hormone, a peptide hormone that stimulates growth
* Human development (biology)
* Plant growth
* Secondary growth ...
, and small cap vs. large cap
Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's outstanding common shares owned by stockholders.
Market capitalization is equal to the market price per common share multiplied by t ...
and investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics an ...
.
In a well-diversified portfolio, achieved investment performance Investment performance is the return on an investment portfolio. The investment portfolio can contain a single asset or multiple assets. The investment performance is measured over a specific period of time and in a specific currency.
Investors o ...
will, in general, largely be a function of the asset mix selected, while the individual securities are less impactful. The specific approach or philosophy will also be significant, depending on the extent to which it is complementary with the market cycle.
A quantitative fund A quantitative fund is an investment fund that uses Quantitative analysis (finance), quantitative investment management instead of fundamental human analysis.
Investment process
:''See for a listing of relevant articles.''
An Investment, investme ...
is managed using computer-based techniques (increasingly, machine learning
Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence.
Machine ...
) instead of human judgment. The actual trading also, is typically automated via sophisticated algorithms.
Risk management
Risk management, in general, is the study of how to control risks and balance the possibility of gains; it is the process of measuring risk and then developing and implementing strategies to manage that risk.
Financial risk management
Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as liste ...
is the practice of protecting corporate value by using financial instruments to manage exposure to risk, here called "hedging"; the focus is particularly on credit and market risk, and in banks, through regulatory capital, includes operational risk.
*Credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
is risk of default on a debt that may arise from a borrower failing to make required payments;
*Market risk
Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility.
There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most ...
relates to losses arising from movements in market variables such as prices and exchange rates;
* Operational risk relates to failures in internal processes, people, and systems, or to external events.
Financial risk management is related to corporate finance in two ways.
Firstly, firm exposure to market risk is a direct result of previous capital investments and funding decisions;
while credit risk arises from the business's credit policy and is often addressed through credit insurance Credit insurance refers to several kinds of insurance relating to financial credit:
* Trade credit insurance, purchased by businesses to insure payment of credit ''extended by'' the business
*Payment protection insurance, purchased by consumers to ...
and provisioning
In telecommunication, provisioning involves the process of preparing and equipping a network to allow it to provide new services to its users. In National Security/Emergency Preparedness telecommunications services, ''"provisioning"'' equates to ...
.
Secondly, both disciplines share the goal of enhancing or at least preserving, the firm's economic value
In economics, economic value is a measure of the benefit provided by a good or service to an economic agent. It is generally measured through units of currency, and the interpretation is therefore "what is the maximum amount of money a specif ...
, and in this context overlaps also enterprise risk management Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives. ERM provides a framework for risk management, which typic ...
, typically the domain of strategic management
In the field of management, strategic management involves the formulation and implementation of the major goals and initiatives taken by an organization's managers on behalf of stakeholders, based on consideration of Resource management, resour ...
.
Here, businesses devote much time and effort to forecasting
Forecasting is the process of making predictions based on past and present data. Later these can be compared (resolved) against what happens. For example, a company might estimate their revenue in the next year, then compare it against the actual ...
, analytics
Analytics is the systematic computational analysis of data or statistics. It is used for the discovery, interpretation, and communication of meaningful patterns in data. It also entails applying data patterns toward effective decision-making. It ...
and performance monitoring
A performance is an act of staging or presenting a play, concert, or other form of entertainment. It is also defined as the action or process of carrying out or accomplishing an action, task, or function.
Management science
In the work place ...
.
See also "ALM" and treasury management
Treasury management (or treasury operations) includes management of an enterprise's holdings, with the ultimate goal of managing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a fi ...
.
For banks and other wholesale institutions, risk management focuses on managing, and as necessary hedging, the various positions held by the institution both trading positions and long term exposures and on calculating and monitoring the resultant economic capital
In finance, mainly for financial services firms, economic capital (ecap) is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market r ...
, and regulatory capital
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ad ...
under Basel III
Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to ...
.
The calculations here are mathematically sophisticated, and within the domain of quantitative finance
Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets.
In general, there exist two separate branches of finance that require ...
as below.
Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to counterparty credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased c ...
.
Banks typically employ Middle office
The middle office is a team of employees working in a financial services institution. Financial services institutions can be divided into three sections: the front, the middle and the back office. The front office is composed of customer-facing emp ...
"Risk Groups" here, whereas front office
The front office is the part of a company that comes in contact with clients, such as the marketing, sales, and service departments. The term has more specific meaning in different industries.
Types
General offices
The function of front office ...
risk teams provide risk "services" / "solutions" to customers.
Additional to diversification the fundamental risk mitigant here investment managers will apply various risk management techniques to their portfolios as appropriate:
these may relate to the portfolio as a whole or to individual stocks; bond portfolios are typically managed via cash flow matching Cash flow matching is a process of hedging in which a company or other entity matches its cash outflows (i.e., financial obligations) with its cash inflows over a given time horizon. It is a subset of immunization strategies in finance. Cash flow ...
or immunization
Immunization, or immunisation, is the process by which an individual's immune system becomes fortified against an infectious agent (known as the immunogen).
When this system is exposed to molecules that are foreign to the body, called ''non-sel ...
.
Re derivative portfolios (and positions), "the Greeks" is a vital risk management tool it measures sensitivity to a small change in a given underlying parameter so that the portfolio can be rebalanced accordingly by including additional derivatives with offsetting characteristics.
Quantitative finance
Quantitative finance also referred to as "mathematical finance" includes those finance activities where a sophisticated mathematical model is required,[See discussion here: ] and thus overlaps several of the above.
As a specialized practice area, quantitative finance comprises primarily three sub-disciplines; the underlying theory and techniques are discussed in the next section:
#Quantitative finance is often synonymous with financial engineering
Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathema ...
. This area generally underpins a bank's customer-driven derivatives business delivering bespoke OTC-contracts and "exotics", and designing
A design is a plan or specification for the construction of an object or system or for the implementation of an activity or process or the result of that plan or specification in the form of a prototype, product, or process. The verb ''to design'' ...
the various structured products and solutions mentioned and encompasses modeling and programming in support of the initial trade, and its subsequent hedging and management.
#Quantitative finance also significantly overlaps financial risk management
Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as liste ...
in banking, as mentioned, both as regards this hedging, and as regards economic capital as well as compliance with regulations and the Basel capital / liquidity requirements.
#"Quants" are also responsible for building and deploying the investment strategies at the quantitative funds mentioned; they are also involved in quantitative investing
Quantitative analysis is the use of mathematical and statistical methods in finance and investment management. Those working in the field are quantitative analysts (quants). Quants tend to specialize in specific areas which may include derivative s ...
more generally, in areas such as trading strategy
In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency ...
formulation, and in automated trading An automated trading system (ATS), a subset of algorithmic trading, uses a computer program to create buy and sell orders and automatically submits the orders to a market center or exchange. The computer program will automatically generate orders ba ...
, high-frequency trading
High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no ...
, algorithmic trading
Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of ...
, and program trading
Program trading is a type of trading in securities, usually consisting of baskets of fifteen stocks or more that are executed by a computer program simultaneously based on predetermined conditions. Program trading is often used by hedge funds an ...
.
Financial theory
Financial theory is studied and developed within the disciplines of management
Management (or managing) is the administration of an organization, whether it is a business, a nonprofit organization, or a government body. It is the art and science of managing resources of the business.
Management includes the activities o ...
, (financial) economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
, accountancy
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "language ...
and applied mathematics
Applied mathematics is the application of mathematical methods by different fields such as physics, engineering, medicine, biology, finance, business, computer science, and industry. Thus, applied mathematics is a combination of mathematical s ...
.
Abstractly, ''finance'' is concerned with the investment and deployment of asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
s and liabilities over "space and time";
i.e., it is about performing valuation and asset allocation
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment tim ...
today, based on the risk and uncertainty of future outcomes while appropriately incorporating the time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The t ...
.
Determining the present value
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of these future values, "discounting", must be at the risk-appropriate discount rate, in turn, a major focus of finance-theory.["Finance"](_blank)
Farlex Financial Dictionary. 2012
Since the debate as 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
This is a list of some of the major unsolved problems, puzzles, or questions in economics. Some of these are theoretical in origin and some of them concern the inability of orthodox economic theory to explain an empirical observation.
Capital the ...
.
Managerial finance
Managerial finance is the branch of management
Management (or managing) is the administration of an organization, whether it is a business, a nonprofit organization, or a government body. It is the art and science of managing resources of the business.
Management includes the activities o ...
that concerns itself with the managerial application of finance techniques and theory, emphasizing the financial aspects of managerial decisions;
the assessment is per the managerial perspectives of planning, directing, and controlling.
The techniques addressed and developed relate in the main to managerial accounting
In management accounting or managerial accounting, managers use accounting information in decision-making and to assist in the management and performance of their control functions.
Definition
One simple definition of management accounting is t ...
and corporate finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and anal ...
:
the former allow management to better understand, and hence act on, financial information relating to profitability
In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs.
It i ...
and performance; the latter, as above, are about optimizing the overall financial structure, including its impact on working capital.
The ''implementation'' of these techniques i.e. financial management
Financial management is the business function concerned with profitability, expenses, cash and credit, so that the "organization may have the means to carry out its objective as satisfactorily as possible;"
the latter often defined as maximizin ...
is outlined above.
Academics working in this area are typically based in business school
A business school is a university-level institution that confers degrees in business administration or management. A business school may also be referred to as school of management, management school, school of business administration, o ...
finance departments, in accounting
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...
, or in management science
Management science (or managerial science) is a wide and interdisciplinary study of solving complex problems and making strategic decisions as it pertains to institutions, corporations, governments and other types of organizational entities. It is ...
.
Financial economics
Financial economics [For an overview, se]
"Financial Economics"
William F. Sharpe
William Forsyth Sharpe (born June 16, 1934) is an American economist. He is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business, and the winner of the 1990 Nobel Memorial Prize in Economic Sciences.
...
(Stanford University manuscript) is the branch of economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
that studies the interrelation of financial variables, such as price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the c ...
s, interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s and shares, as opposed to real
Real may refer to:
Currencies
* Brazilian real (R$)
* Central American Republic real
* Mexican real
* Portuguese real
* Spanish real
* Spanish colonial real
Music Albums
* ''Real'' (L'Arc-en-Ciel album) (2000)
* ''Real'' (Bright album) (2010)
...
economic variables, i.e. goods and services
Goods are items that are usually (but not always) tangible, such as pens, physical books, salt, apples, and hats. Services are activities provided by other people, who include architects, suppliers, contractors, technologists, teachers, doctor ...
.
It thus centers on pricing, decision making, and risk management in the financial market
A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...
s, and produces many of the commonly employed financial model
Financial modeling is the task of building an abstraction, abstract representation (a mathematical model, model) of a real world finance, financial situation. This is a mathematical model designed to represent (a simplified version of) the perfor ...
s. (Financial econometrics
Financial econometrics is the application of statistical methods to financial market data. Financial econometrics is a branch of financial economics, in the field of economics. Areas of study include capital markets, financial institutions, corpo ...
is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.)
The discipline has two main areas of focus:
[See the discussion re finance theory by Fama and Miller under .]
asset pricing
In financial economics, asset pricing refers to a formal treatment and development of two main Price, pricing principles, outlined below, together with the resultant models.
There have been many models developed for different situations, but cor ...
and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital; respectively:
* Asset pricing theory develops the models used in determining the risk-appropriate discount rate, and in pricing derivatives; and includes the portfolio- and investment theory
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing is ...
applied in asset management. The analysis essentially explores how rational investors would apply risk and return to the problem of investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
under uncertainty, producing the key "Fundamental theorem of asset pricing
The fundamental theorems of asset pricing (also: of arbitrage, of finance), in both financial economics and mathematical finance, provide necessary and sufficient conditions for a market to be arbitrage-free, and for a market to be complete. An arb ...
". Here, the twin assumptions of rationality
Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abil ...
and market efficiency
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
lead to modern portfolio theory
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificatio ...
(the CAPM CAPM may refer to:
* Capital asset pricing model, a fundamental model in finance
* Certified Associate in Project Management, an entry-level credential for project managers
{{Disambig ...
), and to the Black–Scholes theory for option valuation
In finance, a price (premium) is paid or received for purchasing or selling options. This article discusses the calculation of this premium in general. For further detail, see: for discussion of the mathematics; Financial engineering for the imp ...
. At more advanced levels and often in response to financial crises
A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
the study then extends these "Neoclassical" models to incorporate phenomena where their assumptions do not hold, or to more general settings.
* Much of corporate finance theory, by contrast, considers investment under "certainty
Certainty (also known as epistemic certainty or objective certainty) is the epistemic property of beliefs which a person has no rational grounds for doubting. One standard way of defining epistemic certainty is that a belief is certain if and ...
" (Fisher separation theorem
In economics, the Fisher separation theorem asserts that the primary objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. The theorem therefore separates management's "product ...
, "theory of investment value", Modigliani–Miller theorem
The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs ...
). Here theory and methods are developed for the decisioning about funding, dividends, and capital structure discussed above. A recent development is to incorporate uncertainty and contingency and thus various elements of asset pricing into these decisions, employing for example real options analysis
Real options valuation, also often termed real options analysis,Adam Borison ( Stanford University)''Real Options Analysis: Where are the Emperor's Clothes?''
(ROV or ROA) applies option valuation techniques to capital budgeting decisions.Campb ...
.
Financial mathematics
Financial mathematics [Research Area: Financial Mathematics and Engineering](_blank)
Society for Industrial and Applied Mathematics is the field of applied mathematics
Applied mathematics is the application of mathematical methods by different fields such as physics, engineering, medicine, biology, finance, business, computer science, and industry. Thus, applied mathematics is a combination of mathematical s ...
concerned with financial market
A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...
s;
Louis Bachelier's doctoral thesis, defended in 1900, is considered to be the first scholarly work in this area.
The field is largely focused on the modeling of derivatives with much emphasis on interest rate- and credit risk modeling while other important areas include insurance mathematics and quantitative portfolio management.
Relatedly, the techniques developed are applied to pricing and hedging a wide range of asset-backed, government
A government is the system or group of people governing an organized community, generally a state.
In the case of its broad associative definition, government normally consists of legislature, executive, and judiciary. Government is a ...
, and corporate
A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and re ...
-securities.
As above, in terms of practice, the field is referred to as quantitative finance and / or mathematical finance, and comprises primarily the three areas discussed.
The main mathematical tools and techniques are, correspondingly:
*for derivatives,[For a survey, se]
"Financial Models"
from Michael Mastro (2013). ''Financial Derivative and Energy Market Valuation'', John Wiley & Sons. . Itô's stochastic calculus, simulation
A simulation is the imitation of the operation of a real-world process or system over time. Simulations require the use of Conceptual model, models; the model represents the key characteristics or behaviors of the selected system or proc ...
, and partial differential equation
In mathematics, a partial differential equation (PDE) is an equation which imposes relations between the various partial derivatives of a Multivariable calculus, multivariable function.
The function is often thought of as an "unknown" to be sol ...
s; see aside boxed discussion re the prototypical Black-Scholes and the various numeric techniques now applied
*for risk management,[See generally, Roy E. DeMeo (N.D.]
Quantitative Risk Management: VaR and Others
/ref> value at risk
Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
, stress testing
Stress testing (sometimes called torture testing) is a form of deliberately intense or thorough testing used to determine the stability of a given system, critical infrastructure or entity. It involves testing beyond normal operational capacity, ...
, "sensitivities" analysis (applying the "greeks"), and xVA
An X-Value Adjustment (XVA, xVA) is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: ...
; the underlying mathematics comprises mixture models
In statistics, a mixture model is a probabilistic model for representing the presence of subpopulations within an overall population, without requiring that an observed data set should identify the sub-population to which an individual observatio ...
, PCA, volatility clustering In finance, volatility clustering refers to the observation, first noted by Mandelbrot (1963), that "large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes." A quantitative manifes ...
and copulas.
*in both of these areas, and particularly for portfolio problems, quants employ sophisticated optimization techniques
Mathematically, these separate into two analytic branches:
derivatives pricing uses risk-neutral probability
In mathematical finance, a risk-neutral measure (also called an equilibrium measure, or ''equivalent martingale measure'') is a probability measure such that each share price is exactly equal to the discounted expectation of the share price und ...
(or arbitrage-pricing probability), denoted by "Q";
while risk and portfolio management generally use physical (or actual or actuarial) probability, denoted by "P".
These are interrelated through the above "Fundamental theorem of asset pricing".
The subject has a close relationship with financial economics, which, as above, is concerned with much of the underlying theory that is involved in financial mathematics: generally, financial mathematics will derive and extend the mathematical model
A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used in the natural sciences (such as physics, ...
s suggested.
Computational finance
Computational finance is a branch of applied computer science that deals with problems of practical interest in finance.Rüdiger U. Seydel, '' tp://nozdr.ru/biblio/kolxo3/F/FN/Seydel%20R.U.%20Tools%20for%20Computational%20Finance%20(4ed.,%20Springe ...
is the branch of (applied) computer science
Computer science is the study of computation, automation, and information. Computer science spans theoretical disciplines (such as algorithms, theory of computation, information theory, and automation) to Applied science, practical discipli ...
that deals with problems of practical interest in finance, and especially emphasizes the numerical methods
Numerical analysis is the study of algorithms that use numerical approximation (as opposed to symbolic manipulations) for the problems of mathematical analysis (as distinguished from discrete mathematics). It is the study of numerical methods th ...
applied here.
Experimental finance
Experimental finance The goals of experimental finance are to understand human and market behavior in settings relevant to finance. Experiments are synthetic economic environments created by researchers specifically to answer research questions. This might involve, for ...
[Bloomfield, Robert and Anderson, Alyssa]
"Experimental finance"
. In Baker, H. Kent, and Nofsinger, John R., eds. Behavioral finance: investors, corporations, and markets. Vol. 6. John Wiley & Sons, 2010. pp. 113-131.
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
Behavioral finance
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory.
...
studies how the ''psychology
Psychology is the scientific study of mind and behavior. Psychology includes the study of conscious and unconscious phenomena, including feelings and thoughts. It is an academic discipline of immense scope, crossing the boundaries betwe ...
'' 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. With more in-depth research into behavioral finance, it is possible to bridge what actually happens in financial markets with analysis based on financial theory.
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 Quantitative behavioral finance is a new discipline that uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation.
The research can be grouped into the following areas:
# Empirical studies that d ...
, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation.
Quantum finance
Quantum finance is an interdisciplinary research field, applying theories and methods developed by quantum physicists
In physics, a quantum (plural quanta) is the minimum amount of any physical entity (physical property) involved in an interaction. The fundamental notion that a physical property can be "quantized" is referred to as "the hypothesis of quantizati ...
and economists in order to solve problems in finance. It is a branch of econophysics
Econophysics is a Heterodox economics, heterodox interdisciplinary research field, applying theories and methods originally developed by physicists in order to solve problems in economics, usually those including uncertainty or stochastic processes ...
.
Finance theory is heavily based on financial instrument pricing such as stock option
In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified dat ...
pricing. Many of the problems facing the finance community have no known analytical solution. As a result, numerical methods and computer simulations for solving these problems have proliferated. This research area is known as computational finance
Computational finance is a branch of applied computer science that deals with problems of practical interest in finance.Rüdiger U. Seydel, '' tp://nozdr.ru/biblio/kolxo3/F/FN/Seydel%20R.U.%20Tools%20for%20Computational%20Finance%20(4ed.,%20Springe ...
. Many computational finance problems have a high degree of computational complexity and are slow to converge to a solution on classical computers. In particular, when it comes to option pricing, there is additional complexity resulting from the need to respond to quickly changing markets. For example, in order to take advantage of inaccurately priced stock options, the computation must complete before the next change in the almost continuously changing stock market. As a result, the finance community is always looking for ways to overcome the resulting performance issues that arise when pricing options. This has led to research that applies alternative computing techniques to finance. Most commonly used quantum financial models are quantum continuous model, quantum binomial model, multi-step quantum binomial model etc.
History of finance
The origin of finance can be traced to the start of civilization. The earliest historical evidence of finance is dated to around 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 period, the Sumerian city of Uruk
Uruk, also known as Warka or Warkah, was an ancient city of Sumer (and later of Babylonia) situated east of the present bed of the Euphrates River on the dried-up ancient channel of the Euphrates east of modern Samawah, Al-Muthannā, Iraq.Harm ...
in Mesopotamia
Mesopotamia ''Mesopotamíā''; ar, بِلَاد ٱلرَّافِدَيْن or ; syc, ܐܪܡ ܢܗܪ̈ܝܢ, or , ) is a historical region of Western Asia situated within the Tigris–Euphrates river system, in the northern part of the F ...
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. The Code of Hammurabi
The Code of Hammurabi is a Babylonian legal text composed 1755–1750 BC. It is the longest, best-organised, and best-preserved legal text from the ancient Near East. It is written in the Old Babylonian dialect of Akkadian, purportedly by Hamm ...
(1792-1750 BC) included laws governing banking operations. The Babylonians were accustomed to charging interest at the rate of 20 percent per annum.
Jews were not allowed to take interest from other Jews, but they were allowed to take interest from Gentiles, who had at that time no law forbidding them from practicing usury. As Gentiles took interest from Jews, the Torah considered it equitable that Jews should take interest from Gentiles. In Hebrew, interest is ''neshek''.
By 1200 BC, cowrie
Cowrie or cowry () is the common name for a group of small to large sea snails, marine gastropod mollusks in the family Cypraeidae, the cowries.
The term ''porcelain'' derives from the old Italian term for the cowrie shell (''porcellana'') d ...
shells were used as a form of money in China
China, officially the People's Republic of China (PRC), is a country in East Asia. It is the world's most populous country, with a population exceeding 1.4 billion, slightly ahead of India. China spans the equivalent of five time zones and ...
. By 640 BC, the Lydians
The Lydians (known as ''Sparda'' to the Achaemenids, Old Persian cuneiform Wikt:𐎿𐎱𐎼𐎭, 𐎿𐎱𐎼𐎭) were Anatolians, Anatolian people living in Lydia, a region in western Anatolia, who spoke the distinctive Lydian language, an ...
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, around 687 BC.)
The use of coins as a means of representing money began in the years between 600 and 570 BCE. Cities under the Greek empire, such as Aegina (595 BCE), Athens (575 BCE), and Corinth (570 BCE), started to mint their own coins. In the Roman Republic
The Roman Republic ( la, Res publica Romana ) was a form of government of Rome and the era of the classical Roman civilization when it was run through public representation of the Roman people. Beginning with the overthrow of the Roman Kin ...
, interest was outlawed altogether by the ''Lex Genucia'' reforms. Under Julius Caesar
Gaius Julius Caesar (; ; 12 July 100 BC – 15 March 44 BC), was a Roman general and statesman. A member of the First Triumvirate, Caesar led the Roman armies in the Gallic Wars before defeating his political rival Pompey in a civil war, and ...
, a ceiling on interest rates of 12% was set, and later under Justinian
Justinian I (; la, Iustinianus, ; grc-gre, Ἰουστινιανός ; 48214 November 565), also known as Justinian the Great, was the Byzantine emperor from 527 to 565.
His reign is marked by the ambitious but only partly realized ''renovat ...
it was lowered even further to between 4% and 8%.
It's said Belgium is the place where the first exchange happened back in approximately 1531. Since, popular exchanges such as
the London Stock Exchange (founded in 1773) and the New York Stock Exchange (founded in 1793) were created.
Image gallery
File:Babylonian - Economic Document - Walters 482030 - View A.jpg, Babylonian tablet, part of the economic archives of the temple of the sky-god Anu
Anu ( akk, , from wikt:𒀭#Sumerian, 𒀭 ''an'' “Sky”, “Heaven”) or Anum, originally An ( sux, ), was the sky father, divine personification of the sky, king of the gods, and ancestor of many of the list of Mesopotamian deities, dei ...
and fertility-goddess Ishtar
Inanna, also sux, 𒀭𒊩𒌆𒀭𒈾, nin-an-na, label=none is an ancient Mesopotamian goddess of love, war, and fertility. She is also associated with beauty, sex, divine justice, and political power. She was originally worshiped in S ...
at Uruk
Uruk, also known as Warka or Warkah, was an ancient city of Sumer (and later of Babylonia) situated east of the present bed of the Euphrates River on the dried-up ancient channel of the Euphrates east of modern Samawah, Al-Muthannā, Iraq.Harm ...
, recording a payment made in c. 549 BC
File:Emanuel de Witte - De binnenplaats van de beurs te Amsterdam.jpg, alt=Courtyard of the Amsterdam Stock Exchange, 1653, the world's first formal stock exchange., Courtyard of the Amsterdam Stock Exchange
Euronext Amsterdam is a stock exchange based in Amsterdam, the Netherlands. Formerly known as the Amsterdam Stock Exchange, it merged on 22 September 2000 with the Brussels Stock Exchange and the Paris Stock Exchange to form Euronext. The r ...
, 1653, the world's first formal stock exchange
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for th ...
File:Dojima-Rice-Exchange-Osaka-by-Yoshimitsu-Sasaki.png, alt=Dōjima Rice Exchange, the world's first futures exchange, established in Osaka in 1697., Dōjima Rice Exchange
The Dōjima Rice Exchange (堂島米市場, ''Dōjima kome ichiba'', 堂島米会所, ''Dōjima kome kaisho''), located in Osaka, was the center of Japan's system of rice brokers, which developed independently and privately in the Edo period ...
, the world's first futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or f ...
, established in Osaka
is a designated city in the Kansai region of Honshu in Japan. It is the capital of and most populous city in Osaka Prefecture, and the third most populous city in Japan, following Special wards of Tokyo and Yokohama. With a population of 2. ...
in 1697
See also
*Outline of finance
The following outline is provided as an overview of and topical guide to finance:
Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed in ...
*Financial crisis of 2007–2010
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
Notes
References
Further reading
*
*
*''Rich Dad Poor Dad
''Rich Dad Poor Dad'' is a 1997 book written by Robert T. Kiyosaki and Sharon Lechter. It advocates the importance of financial literacy (financial education), financial independence and building wealth through investing in assets, real estate i ...
: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!'', by Robert Kiyosaki
Robert Toru Kiyosaki (born April 8, 1947) is an Japanese-American, American entrepreneur, businessman and author. Kiyosaki is the founder of Rich Global LLC and the Rich Dad, Rich Dad Company, a private financial education company that provides ...
and Sharon Lechter
Sharon L. Lechter (born January 12, 1954) is an American accountant, author, and businesswoman. She is the co-author of '' Rich Dad Poor Dad'', and the founder and CEO of Pay Your Family First, a financial education organization.
In January 2008, ...
. Warner Business Books
Hachette Book Group (HBG) is a publishing company owned by Hachette Livre, the largest publishing company in France, and the third largest trade and educational publisher in the world. Hachette Livre is a wholly owned subsidiary of Lagardère Grou ...
, 2000.
*
*
*
*
*
External links
Finance Definition - Investopedia
Finance Definition - Corporate Finance Institute
(Campbell Harvey
Campbell Russell "Cam" Harvey (born June 23, 1958) is a Canadian economist, known for his work on asset allocation with changing risk and risk premiums and the problem of separating luck from skill in investment management. He is currently the J. ...
)
Corporate finance resources
(Aswath Damodaran
Aswath Damodaran (born 24 September 1957), is a Professor of Finance at the Stern School of Business at New York University (Kerschner Family Chair in Finance Education), where he teaches corporate finance and equity valuation.
Background
Know ...
)
Financial management resources
(James Van Horne
James Carter Van Horne (born 1935) is an American economist.
Van Horne completed his bachelor's degree at DePauw University in 1957, followed by master's doctoral degrees at Northwestern University in 1961 and 1964, respectively. In 1965, Van Horn ...
)
Financial mathematics, derivatives, and risk management resources
(Don Chance)
Personal finance resources
(Financial Literacy and Education Commission The Financial Literacy and Education Commission (the Commission) was established under Title V, the Financial Literacy and Education Improvement Act which was part of the Fair and Accurate Credit Transactions Act (FACT) Act of 2003, to improve fina ...
, mymoney.gov)
Public Finance resources
(Governance and Social Development Resource Centre, gsdrc.org)
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