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 ...
and
capital assets. It is related to, but not synonymous with
economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...
, 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, doc ...
(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"Financia ...
bridges the two).
Finance activities take place in
financial systems 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 r ...
, 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 achiev ...
.
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,
stocks,
options,
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 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 of ownership that can ...
,
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 environm ...
and
investment management aim to maximize value and minimize
volatility.
Financial analysis 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 ...
, covered by
experimental finance.
Some fields are multidisciplinary, such as
mathematical finance,
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"Financia ...
,
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 mathem ...
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 r ...
. These fields are the foundation of
business and
accounting.
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. 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 finan ...
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
As above, the financial system consists of the flows of capital that take place between individuals and households (
personal finance), 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 achiev ...
), and businesses (
corporate finance).
"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 ...
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, 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 inst ...
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 Comm ...
).
The owners of both bonds and stock may be ''
institutional investors'' 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 d ...
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 dat ...
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, bu ...
.
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, 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 ...
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 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 i ...
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 ...
,
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, 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,
swaps, and
structured products, 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 mathem ...
" is
inherently mathematical, and these institutions are then the major employers of
"quants" (see
below).
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 ...
, and
compliance 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
investments, 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
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
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 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, 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 projects ...
: selecting which projects to invest in here, accurately determining value is crucial, as judgements about asset values can be "make or break"
# Dividend policy: the use of "excess" funds are these to be reinvested in the business or returned to shareholders
# Capital structure: deciding on the mix of funding to be used here attempting to find the optimal capital mix re debt-commitments vs cost of capital
The latter creates the link with investment banking 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 bonds, and equity, often listed shares.
Re risk management within corporates, see below.
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, credit and debtors), 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 bonds 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 territori ...
and the Bank of England 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 European mainland, continental mainland. It comprises England, Scotlan ...
, 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, 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 ...
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 Adminis ...
is primarily used for infrastructure 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 investments 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 t ...
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, e.g. currency exchange limits.
Explanation
As globalization integrates the economies of neighboring and of trad ...
, 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 o ...
). 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 sta ...
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 o ...
, 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 a ...
.
In a well-diversified portfolio, achieved investment performance 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 investment management instead of fundamental human analysis.
Investment process
:''See for a listing of relevant articles.''
An investment process is classified as quantitative wh ...
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
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 speci ...
, 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 typi ...
, typically the domain of strategic management.
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 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 ...
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 t ...
.
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.
Banks typically employ Middle office Investment_banking#Risk_management, "Risk Groups" here, whereas front office risk teams provide risk "services" / "solutions" to customers.
Additional to diversification the fundamental risk mitigant here Financial risk management#Investment management, investment managers will apply various risk management techniques to their portfolios as appropriate:
these may relate to the Portfolio insurance, portfolio as a whole or Hedge (finance)#Hedging a stock price, to individual stocks; Bond fund, bond portfolios are typically managed via cashflow matching, cash flow matching or immunization (finance), immunization.
Re derivative portfolios (and positions), Greeks (finance)#Use of the Greeks, "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 Financial modeling#Quantitative finance, 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 #Financial mathematics, 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 mathem ...
. This area generally underpins a bank's Investment banking#Sales and trading, customer-driven derivatives business delivering bespoke Over-the-counter (finance)#Contracts, OTC-contracts and exotic derivative, "exotics", and Structured product#Product design and manufacture, designing the various structured products and solutions mentioned and encompasses Financial_modeling#Quantitative_finance, modeling and programming in support of the initial trade, and its subsequent hedging and management.
#Quantitative finance also significantly overlaps financial risk management in banking, as #Risk management, mentioned, both as regards this hedging, and as regards economic capital as well as compliance with regulations and Basel III, the Basel capital / liquidity requirements.
#"Quants" are also responsible for building and deploying the investment strategies at the quantitative funds #Investment management, mentioned; they are also involved in Outline of finance#Quantitative investing, quantitative investing more generally, in areas such as trading strategy formulation, and in automated trading, high-frequency trading, algorithmic trading, and program trading.
Financial theory
Financial theory is studied and developed within the disciplines of Management#Training, management, financial economics, (financial) economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...
, accountancy and applied mathematics.
Abstractly, ''finance'' is concerned with the investment and deployment of assets and Liability (financial accounting), liabilities over "space and time";
i.e., it is about performing valuation (finance), 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 t ...
today, based on the risk and uncertainty of future outcomes while appropriately incorporating the time value of money.
Determining the present value of these future values, "discounting", must be at the required rate of return, 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.
Managerial finance
Managerial finance is the branch of management that concerns itself with the Management#Implementation of policies and strategies, managerial application of financial analysis, finance techniques and theory, emphasizing the financial aspects of managerial decisions;
the assessment is per the Management#Theoretical scope, managerial perspectives of planning, directing, and controlling.
The techniques addressed and developed relate in the main to managerial accounting and corporate finance:
the former allow management to better understand, and hence act on, financial information relating to profitability 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 #Corporate finance, above.
Academics working in this area are typically based in business school finance departments, in accounting, or in management science.
Financial economics
Financial economics [For an overview, se]
"Financial Economics"
William F. Sharpe (Stanford University manuscript) is the branch of economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...
that studies the interrelation of financial Variable (mathematics), variables, such as prices, interest rates and shares, as opposed to Real vs. nominal in economics, real 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, doc ...
.
It thus centers on pricing, decision making, and risk management in the financial markets, and produces many of the commonly employed financial models. (Financial econometrics 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 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 outline of finance#Portfolio theory, portfolio- and investment theory applied in asset management. The analysis essentially explores how homo economicus, rational investors would apply risk and return to the problem of investment under uncertainty, producing the key "Fundamental theorem of asset pricing". Here, the twin assumptions of rational pricing, rationality and efficient-market hypothesis, market efficiency lead to modern portfolio theory (the Capital asset pricing model, CAPM), and to the Black–Scholes model, Black–Scholes theory for Valuation of options, option valuation. At more advanced levels and often in response to financial crisis, financial crises the study Financial economics#Extensions, then extends these Neoclassical economics#Rational Behavior Assumptions, "Neoclassical" models to incorporate phenomena where their assumptions do not hold, or to more general settings.
* Much of Outline of finance#Corporate finance theory, corporate finance theory, by contrast, considers investment under "certainty" (Fisher separation theorem, The Theory of Investment Value, "theory of investment value", Modigliani–Miller theorem). Here theory and methods are developed for the decisioning about funding, dividends, and capital structure discussed above. A recent development is Financial economics#Corporate finance theory, to incorporate uncertainty and contingent claim valuation, contingency and thus various elements of asset pricing into these decisions, employing for example real options analysis.
Financial mathematics
Financial mathematics [Research Area: Financial Mathematics and Engineering](_blank)
Society for Industrial and Applied Mathematics is the field of applied mathematics concerned with financial markets;
Louis_Bachelier#The_thesis, 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 Outline of finance#Derivatives pricing, modeling of derivatives with much emphasis on Interest rate derivative, interest rate- and Credit derivative, credit risk modeling while other important areas include actuarial science, insurance mathematics and Outline of finance#Mathematical techniques, quantitative portfolio management.
Relatedly, the techniques developed contingent claim analysis, are applied to pricing and hedging a wide range of Asset-backed security, asset-backed, Government bond, government, and Capital structure, corporate-securities.
As #Quantitative_finance, 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 Outline of finance#Mathematical tools, 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 calculus, Itô's stochastic calculus, Monte Carlo methods in finance, simulation, and partial differential equations; see aside boxed discussion re the prototypical Black-Scholes and Valuation_of_options#Pricing_models, 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, stress test (financial), stress testing, PnL Explained#Sensitivities method, "sensitivities" analysis (applying the "greeks"), and xVA; the underlying mathematics comprises Mixture model#A financial model, mixture models, Principal component analysis#Quantitative finance, PCA, volatility clustering and Copula_(probability_theory)#Quantitative_finance, copulas.
*in both of these areas, and particularly for portfolio problems, quants employ Outline of finance#Mathematical techniques, sophisticated optimization techniques
Mathematically, these separate into Mathematical finance#History: Q versus P, two analytic branches:
derivatives pricing uses Risk-neutral measure, risk-neutral probability (or rational pricing, 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 models suggested.
Computational finance is the branch of (applied) computer science that deals with problems of practical interest in finance, and especially emphasizes the numerical methods applied here.
Experimental finance
Experimental finance[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 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. 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, 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 physics, quantum physicists and economists in order to solve problems in finance. It is a branch of econophysics.
Finance theory is heavily based on financial instrument pricing such as stock option 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. 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 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. The Code of Hammurabi (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 shells were used as a form of money in China. 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, 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 Ancient Greece, Greek empire, such as Aegina (595 BCE), Athens (575 BCE), and Corinth (570 BCE), started to mint their own coins. In the Roman Republic, interest was outlawed altogether by the ''Lex Genucia'' reforms. Under 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%.
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 mathematics, Babylonian tablet, part of the economic archives of the temple of the sky-god Anu and fertility-goddess Ishtar at Uruk, 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, 1653, the world's first formal stock exchange
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 world's first futures exchange, established in Osaka in 1697
See also
*Outline of finance
*Financial crisis of 2007–2010
Notes
References
Further reading
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*''Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!'', by Robert Kiyosaki and Sharon Lechter. Warner Business Books, 2000.
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External links
Finance Definition - Investopedia
Finance Definition - Corporate Finance Institute
(Campbell Harvey)
Corporate finance resources
(Aswath Damodaran)
Financial management resources
(James Van Horne)
Financial mathematics, derivatives, and risk management resources
(Don Chance)
Personal finance resources
(Financial Literacy and Education Commission, mymoney.gov)
Public Finance resources
(Governance and Social Development Resource Centre, gsdrc.org)
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