Finance is a term for matters regarding the creation, management and study of money
Savers and investors have money available which could earn interest or dividends if put to productive use. Individuals, companies and governments must obtain money from some external source, such as loans or credit, when they lack sufficient funds to operate. Finance is the process of channeling money from savers and investors to entities that need them. Specifically, it deals with how and why an individual, company
acquires the money needed called capital
in the company context and how they spend or invest that money.
Farlex Financial Dictionary. 2012
Finance has also been defined as the study of how to determine the value of assets such as stocks, bonds, loans, commodities, and by extension entire companies. Accurately determining value is crucial to sound business decisions. In some cases, such as one company acquiring another or entering a new line of business, judgements about asset values can make or break the investor.
* the operations of financial market
s and the financial services
sector, which enable the flow of money
within the economy via banking, investments and other financial instruments
* investment management
, securities trading
and stock brokerage
* investment bank
* financial engineering
* risk management
It is often split into the following major categories: corporate finance
, personal finance
and public finance
Given its wide scope, finance is studied in several academic disciplines, and there are several related professional qualifications
that lead to the field.
History of finance
The origins of finance can be traced to the start of civilization. The earliest historical evidence of finance is dated back from 3000 BC. Banking originated in the Babylonian empire, where temples and palaces were used as safe places for the storage of valuables. Initially, the only valuable that could be deposited was grain, but cattle and precious materials were eventually included. During the same time period, the Sumerian city of Uruk in Mesopotamia
supported trade by lending as well as the use of interest. In Sumerian, “interest” was ''mas'', which translates to "calf". In Greece and Egypt, the words used for interest, ''tokos'' and ''ms'' respectively, meant “to give birth”. In these cultures, interest indicated a valuable increase, and seemed to consider it from the lender’s point of view. During the Reign of Hammurabi
(1792-1750 BC) in Babylon
, the Code of Hammurabi
included laws governing banking operations. The Babylonians were accustomed to charge interest at the rate of 20 per cent per annum.
In the Biblical world point of view within the Jewish Civilization (1500 BC), Jews were not allowed to take interest from other Jews, but they were allowed to take interest from the gentiles. The reason for the non-prohibition of the receipt by a Jew of interest from a Gentile, and vice versa, is held by modern rabbis to lay in the fact that the Gentiles had at that time no law forbidding them to practice usury. As they took interest from Jews, the Torah considered it equitable that Jews should take interest from Gentiles. In Hebrew, interest is neshek. As opposed to other ancient civilizations, interest is considered from borrower's point of view.
By 1200 BC, Cowrie
shells were used as a form of money in China
, and by 640 BC, the Lydians
had started to use coin money. Lydia was the first place where permanent retail shops opened. (Herodotus mentions the use of crude coins in Lydia in an earlier date, i.e. 687 BC.)
In 600 BC, Pythius
became the first banker that had records, and operated in both Western Anatolia and Greece. The use of coins as a means of representing money began in the years between (600-570 BC). Cities under the Greek empire, such as Aegina (595 B.C.), Athens (575 B.C.) and Corinth (570 B.C.), started to mint their own coins. Leading thinkers and statesmen, such as Cato the Elder
, Cato the Younger
, and Plutarch
were against usury
. In the Roman Republic
, interest was outlawed altogether by the Lex Genucia reforms. Under the banner of Julius Caesar
, a ceiling on interest rates of 12% was set, and later under Justinian
, it was lowered even further to between 4% and 8%.
The financial system
The financial system consists of the flows of capital that take place between individuals (personal finance
), governments (public finance
), and businesses (corporate finance
). Although they are closely related, the disciplines of economics and finance are distinct. The economy
is a social institution that organizes a society's production, distribution, and consumption of goods and services, all of which must be financed.
In general, an entity whose income exceeds its expenditure
can lend or invest the excess, intending to earn a fair return. Correspondingly, an entity where income is less than expenditure can raise capital usually in one of two ways:
(i) by borrowing in the form of a loan (private individuals), or by selling government or corporate bonds
(ii) by a corporate selling equity
, also called stock or shares (may take various forms: preferred stock
or common stock
The owners of both bonds and stock may be ''institutional investor
s'' financial institutions such as investment banks and pension funds
– or private individuals, called ''private investors
'' or ''retail investors''.
is often indirect, through a financial intermediary
such as a bank
, or via the purchase of notes or bonds
, government bond
s, or mutual bonds) in the bond market
The lender receives interest, the borrower
pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Investing typically entails the purchase of stock
, either individual securities, or via a mutual fund
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
s. The investment banks find the initial investors and facilitate the listing of the securities, such as equity and debt. Additionally, they facilitate the securities exchange
s, which allow their trade thereafter, as well as the various service providers which manage the performance or risk of these investments.
Areas of finance
Personal finance is defined as "the mindful planning of monetary spending and saving, while also considering the possibility of future risk". Personal finance may involve paying for education, financing durable good
s such as real estate
and cars, buying insurance
, investing, and saving for retirement
Personal finance may also involve paying for a loan or other debt obligations.
The main areas of personal finance are considered to be income, spending, saving, investing, and protection.
The following steps, as outlined by the Financial Planning Standards Board, suggest that an individual will understand a potentially secure personal finance plan after:
* Purchasing insurance to ensure protection against unforeseen personal events;
* Understanding the effects of tax policies, subsidies, or penalties on the management of personal finances;
* Understanding the effects of credit on individual financial standing;
* Developing a savings plan or financing for large purchases (auto, education, home);
* Planning a secure financial future in an environment of economic instability;
* Pursuing a checking and/or a savings account;
* Preparing for retirement or other long term expenses.
Corporate finance deals with the sources of funding and the capital structure
of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources.
Short term financial management
is often termed "working capital management
", and relates to cash
s management. In the longer term, corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock
. It generically entails three primary areas of capital resource allocation:
#Capital budgeting: selecting which projects to invest in;
: the use of "excess" capital;
#Sources of capital: which funding is to be used.
The latter creates the link with investment banking
and securities trading
, in that the capital raised will generically comprise debt, i.e. corporate bond
s, and equity
, often listed shares
While corporate finance is in principle different from managerial finance, which studies the financial management of all firms rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Although financial management overlaps with the financial function of the accounting profession
, financial accounting
is the reporting of historical financial information, whereas as discussed, financial management is concerned with increasing the firm's Shareholder
value and increasing their rate of return on the investment.
In this context, Financial risk management
is about protecting the firm's economic value
by using financial instrument
s to manage exposure to risk
, particularly credit risk
and market risk
, often arising from the firm's funding structures.
Public finance describes finance as related to sovereign states, sub-national entities, and related public entities or agencies. It generally encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods typically encompass five or more years. Public finance is primarily concerned with:
* Identification of required expenditure of a public sector entity;
* Source(s) of that entity's revenue;
* The budgeting process;
* Debt issuance, or municipal bond
s, for public works projects.
Central banks, such as the Federal Reserve System
banks in the United States
and Bank of England
in the United Kingdom
, are strong players in public finance. They act as lenders of last resort
as well as strong influences on monetary and credit conditions in the economy.
Financial theory is studied and developed within the disciplines of management
, (financial) economics
and applied mathematics
Abstractly, ''finance'' is concerned with the investment and deployment of asset
s and liabilities
over "space and time"; it is about performing valuation
and asset allocation
today, based on risk and uncertainty of future outcomes while
incorporating the time value of money
. It includes determining the present value
of these future values; "discounting" requires a risk-appropriate discount rate
Since the debate to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance
Financial economics is the branch of economics
that studies the interrelation of financial variables
, such as price
s, interest rate
s and shares, as opposed to goods and services
. Financial economics concentrates on influences of real
economic variables on financial ones. In contrast to pure finance, it centers on pricing and managing risk management in the financial market
s, and thus produces many commonly employed financial model
It is a field that essentially explores how rational investors
would apply risk and return to the problem of investment
. The twin assumptions of rationality
and market efficiency
lead to modern portfolio theory
), and to the Black–Scholes
theory for option valuation
; it further studies phenomena and models where these assumptions do not hold, or are extended.
Financial economics also considers investment under "certainty
" (see Fisher separation theorem
, "theory of investment value"
, Modigliani–Miller theorem
) and hence contributes to corporate finance theory.
is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Financial mathematics is a field of applied mathematics
concerned with financial market
s. The subject has a close relationship with the discipline of financial economics
, which is concerned with much of the underlying theory that is involved in financial mathematics. Generally, mathematical finance
will derive and extend the mathematical
models suggested by financial economics.
The field is largely focused on the modelling of derivatives
, although other important subfields include insurance mathematics
and quantitative portfolio problems
(See Outline of finance#Mathematical tools
and Outline of finance#Derivatives pricing
In terms of practice, mathematical finance overlaps heavily with the field of computational finance
, also known as ''financial engineering
''. While these are largely synonymous, the latter focuses on application, and the former focuses on modeling and derivation (''see: Quantitative analyst
''). There is also a significant overlap with financial risk management
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.
studies how the ''psychology
'' of investors or managers affects financial decisions and markets, and is relevant when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become an integral aspect of finance.
Behavioral finance includes such topics as:
# Empirical studies that demonstrate significant deviations from classical theories;
# Models of how psychology affects and impacts trading and prices;
# Forecasting based on these methods;
# Studies of experimental asset markets and the use of models to forecast experiments.
A strand of behavioral finance has been dubbed quantitative behavioral finance
, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation.
* Financial crisis of 2007–2010
* Outline of finance
Wharton Finance Knowledge Project
Corporate finance resources
Financial management resources
(James Van Horne