1. FinanceFinance is often defined simply as the management of money or “funds”management. Modern finance, however,is a family of business activitythat includes the origination, marketing, and management of cash andmoneysurrogates through a variety of capital accounts, instruments, andmarkets created for transacting and trading assets,liabilities, and risks.Finance is conceptualized, structured, and regulated by a complex systemof power relationswithin political economies across state and globalmarkets. Finance is both art (e.g. product development) andscience (e.g.measurement), although these activities increasingly converge throughthe intense technical andinstitutional focus on measuring and hedgingrisk-return relationships that underlie shareholder value. Networks offinancial businesses exist to create, negotiate, market, and trade inevermore-complex financial products and services for their own as wellas their clients’ accounts. Financial performance measures assess theefficiency and profitability of investments, the safety of debtors’ claimsagainst assets, and the likelihood that derivative instruments will protectinvestors against a variety of market risks.The financial system consists of public and private interests and themarkets that serve them. It provides capital from individual andinstitutional investors who transfer money directly and throughintermediaries (e.g. banks, insurance companies, brokerage and fundmanagement firms) to other individuals, firms, and governments thatacquire resources and transact business. With the expectation of reapingprofits, investors fund credit in the forms of (1) debt capital (e.g.corporate and government notes and bonds, mortgage securities andother credit instruments), (2) equity capital (e.g. listed and unlistedcompany shares), and (3) the derivative products of a wide variety ofcapital investments including debt and equity securities, property,commodities, and insurance products. Although closely related, thedisciplines of economics and finance are distinctive. The “economy” is asocial institution that organizes a society’s production, distribution, andconsumption of goods and services,” all of which must be financed.Economists make a number of abstract assumptions for purposes of theiranalyses and predictions. They generally regard financial markets thatfunction for the financial system as an efficient mechanism. In practice,however, emerging research is demonstrating that such assumptions are
2. unreliable. Instead, financial markets are subject to human error andemotion. New research discloses the mischaracterization of investmentsafety and measures of financial products and markets so complex thattheir effects, especially under conditions of uncertainty, are impossible topredict. The study of finance is subsumed under economics as financeeconomics, but the scope, speed, power relations and practices of thefinancial system can uplift or cripple whole economies and the well-beingof households, businesses and governing bodies withinthem—sometimes in a single day. Three overarching divisions existwithin the academic discipline of finance and its related practices: 1)personal finance: the finances of individuals and families concerninghousehold income and expenses, credit and debt management, savingand investing, and income security in later life, 2) corporate finance: thefinances of for-profit organizations including corporations, trusts,partnerships and other entities, and 3) public finance: the financialaffairs of domestic and international governments and other publicentities. Areas of study within (and the interactions among) these threelevels affect all dimensions of social life: politics, taxes, art, religion,housing, health care, poverty and wealth, consumption, sports,transportation, labor force participation, media, and education. Whileeach has a vast accumulated literature of its own, the effects of macroand micro level financing that mold and impact these and other domainsof human and societal life typically have been treated by researchers as“policy,” “welfare,” “work,” “stratification,” and so forth, or have beenlargely unexplored. Recent research in "behavioral finance" is promising,albeit a relative newcomer, to the existing body of financial research thatfocuses primarily on measurement. Loans have become increasinglypackaged for resale, meaning that an investor buys the loan (debt) from abank or directly from a corporation. Bonds are debt instruments sold toinvestors for organizations such as companies, governments or charities.The investor can then hold the debt and collect the interest or sell thedebt on a secondary market. Banks are the main facilitators of fundingthrough the provision of credit, although private equity,Finance 2 mutualfunds, hedge funds, and other organizations have become important asthey invest in various forms of debt. Financial assets, known asinvestments, are financially managed with careful attention to financialrisk management to control financial risk. Financial instruments allowmany forms of securitized assets to be traded on securities exchangessuch as stock exchanges, including debt such as bonds as well as equity
3. in publicly traded corporations. Central banks, such as the FederalReserve System banks in the United States and Bank of England in theUnited Kingdom, are strong players in public finance, acting as lendersof last resort as well as strong influences on monetary and creditconditions in the economy. Overview of techniques and sectors of the financial industryAn entity whose income exceeds its expenditure can lend or invest theexcess income. On the other hand, an entitywhose income is less than its expenditure can raise capital by borrowingor selling equity claims, decreasing itsexpenses, or increasing its income. The lender can find a borrower, afinancial intermediary such as a bank, or buynotes or bonds in the bond market. The lender receives interest, theborrower pays a higher interest than the lenderreceives, and the financial intermediary earns the difference for arrangingthe loan.A bank aggregates the activities of many borrowers and lenders. A bankaccepts deposits from lenders, on which itpays interest. The bank then lends these deposits to borrowers. Banksallow borrowers and lenders, of different sizes,to coordinate their activity.Finance is used by individuals (personal finance), by governments (publicfinance), by businesses (corporatefinance) and by a wide variety of other organizations, including schoolsand non-profit organizations. In general, thegoals of each of the above activities are achieved through the use ofappropriate financial instruments andmethodologies, with consideration to their institutional setting.Finance is one of the most important aspects of business managementand includes decisions related to the use andacquisition of funds for the enterprise.In corporate finance, a companys capital structure is the total mix offinancing methods it uses to raise funds. Onemethod is debt financing, which includes bank loans and bond sales.Another method is equity financing - the sale ofstock by a company to investors, the original shareholders of a share.Ownership of a share gives the shareholdercertain contractual rights and powers, which typically include the right to
4. receive declared dividends and to vote theproxy on important matters (e.g., board elections). The owners of bothbonds and stock, may be institutionalinvestors - financial institutions such as investment banks and pensionfunds — or private individuals, called privateinvestors or retail investors. Areas of financePersonal financeQuestions in personal finance revolve around• How much money will be needed by an individual (or by a family), andwhen?• How can people protect themselves against unforeseen personal events,as well as those in the external economy?• How can family assets best be transferred across generations (bequestsand inheritance)?• How does tax policy (tax subsidies or penalties) affect personalfinancial decisions?• How does credit affect an individuals financial standing?• How can one plan for a secure financial future in an environment ofeconomic instability?Personal financial decisions may involve paying for education, financingdurable goods such as real estate and cars,buying insurance, e.g. health and property insurance, investing andsaving for retirement.Personal financial decisions may also involve paying for a loan, or debtobligations.Finance 3Corporate financeManagerial or corporate finance is the task of providing the funds for acorporations activities (for small business,this is referred to as SME finance). Corporate finance generally involvesbalancing risk and profitability, whileattempting to maximize an entitys wealth and the value of its stock, andgenerically entails three interrelateddecisions. In the first, "the investment decision", management mustdecide which "projects" (if any) to undertake.The discipline of capital budgeting is devoted to this question, and mayemploy standard business valuationtechniques or even extend to real options valuation; see Financialmodeling. The second, "the financing decision"
5. relates to how these investments are to be funded: capital here isprovided by shareholders, in the form of equity(privately or via an initial public offering), creditors, often in the form ofbonds, and the firms operations (cashflow). Short-term funding or working capital is mostly provided by banksextending a line of credit. The balancebetween these elements forms the companys capital structure. The third,"the dividend decision", requiresmanagement to determine whether any unappropriated profit is to beretained for future investment / operationalrequirements, or instead to be distributed to shareholders, and if so inwhat form. Short term financial management isoften termed "working capital management", and relates to cash-,inventory- and debtors management. These areasoften overlap with the firms accounting function, however, financialaccounting is more concerned with thereporting of historical financial information, while these financialdecisions are directed toward the future of thefirm.Finance of public entitiesPublic finance describes finance as related to sovereign states andsub-national entities (states/provinces, counties,municipalities, etc.) and related public entities (e.g. school districts) oragencies. It is concerned with:• Identification of required expenditure of a public sector entity• Source(s) of that entitys revenue• The budgeting process• Debt issuance (municipal bonds) for public works projectsFinancial risk managementFinancial risk management is the practice of creating and protectingeconomic value in a firm by using financialinstruments to manage exposure to risk, particularly credit risk andmarket risk. (Other risk types include Foreignexchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.) Itfocuses on when and how to hedge usingfinancial instruments; in this sense it overlaps with financial engineering.Similar to general risk management,financial risk management requires identifying its sources, measuring it(see: Risk measure: Well known risk
6. measures), and formulating plans to address these, and can be qualitativeand quantitative. In the banking sectorworldwide, the Basel Accords are generally adopted by internationallyactive banks for tracking, reporting andexposing operational, credit and market risks. Finance theoryFinancial economicsFinancial economics is the branch of economics studying theinterrelation of financial variables, such as prices,interest rates and shares, as opposed to those concerning the realeconomy. Financial economics concentrates oninfluences of real economic variables on financial ones, in contrast topure finance. It centres on decision makingunder uncertainty in the context of the financial markets, and theresultant economic and financial models. Itessentially explores how rational investors would apply decision theory tothe problem of investment. Here, the twinassumptions of rationality and market efficiency lead to modernportfolio theory (the CAPM), and to the BlackScholes theory for option valuation; it further studies phenomena andmodels where these assumptions do not hold,Finance 4or are extended. "Financial economics", at least formally, also considersinvestment under "certainty" (Fisherseparation theorem, "theory of investment value", Modigliani-Millertheorem) and hence also contributes tocorporate finance theory. Financial Econometrics is the branch ofFinancial Economics that uses econometrictechniques to parameterize the relationships suggested.Financial mathematicsFinancial mathematics is a field of applied mathematics, concerned withfinancial markets. The subject has a closerelationship with the discipline of financial economics, which isconcerned with much of the underlying theory.Generally, mathematical finance will derive, and extend, themathematical or numerical models suggested byfinancial economics. In terms of practice, mathematical finance alsooverlaps heavily with the field of computationalfinance (also known as financial engineering). Arguably, these are largelysynonymous, although the latter focuses
7. on application, while the former focuses on modeling and derivation (see:Quantitative analyst). The field is largelyfocused on the modelling of derivatives, although other importantsubfields include insurance mathematics andquantitative portfolio problems. See Outline of finance: Mathematicaltools; Outline of finance: Derivatives pricing.Experimental financeExperimental finance aims to establish different market settings andenvironments to observe experimentally andprovide a lens through which science can analyze agents behavior andthe resulting characteristics of trading flows,information diffusion and aggregation, price setting mechanisms, andreturns processes. Researchers in experimentalfinance can study to what extent existing financial economics theorymakes valid predictions, and attempt todiscover new principles on which such theory can be extended. Researchmay proceed by conducting tradingsimulations or by establishing and studying the behaviour of people inartificial competitive market-like settings.Behavioral financeBehavioral Finance studies how the psychology of investors or managersaffects financial decisions and markets.Behavioral finance has grown over the last few decades to become centralto finance.Behavioral finance includes such topics as:1. Empirical studies that demonstrate significant deviations from classicaltheories.2. Models of how psychology affects trading and prices3. Forecasting based on these methods.4. Studies of experimental asset markets and use of models to forecastexperiments.A strand of behavioral finance has been dubbed Quantitative BehavioralFinance, which uses mathematical andstatistical methodology to understand behavioral biases in conjunctionwith valuation. Some of this endeavor hasbeen led by Gunduz Caginalp (Professor of Mathematics and Editor ofJournal of Behavioral Finance during2001-2004) and collaborators including Vernon Smith (2002 NobelLaureate in Economics), David Porter, Don
8. Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, RaySturm and others have demonstratedsignificant behavioral effects in stocks and exchange traded funds.Among other topics, quantitative behavioralfinance studies behavioral effects together with the non-classicalassumption of the finiteness of assets.Finance 5Intangible asset financeIntangible asset finance is the area of finance that deals with intangibleassets such as patents, trademarks, goodwill,reputation, etc.