Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects. The term finance may thus incorporate any of the following:
- The study of money and other assets
- The management of those assets
- Profiling and managing project risks
- As a verb, "to finance" is to provide funds for business.
Examples of some basic financial concepts
The activity of finance is the application of a set of techniques that individuals and organizations (entities) use to manage their financial affairs, particularly the differences between income and expenditure and the risks of their investments.
An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower, a financial intermediary, such as a bank or buy notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary pockets the difference.
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. Banks are thus compensators of money flows in space since they allow different lenders and borrows to meet, and in time, since every borrower will eventually pay back.
Finance of individuals, business, and states: Finance is used by Individuals (personal finance), by governments (public finance), by businesses (corporate finance, etc.) as well as by a wide variety of organizations including schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments, with consideration to their institutional setting.
Questions in personal finance revolve around
- How much money will be needed by an individual (or a family) at various points in the future?
- How is that need to be funded?
Personal financial decisions involve paying for education, financing durable goods s.a. real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
In the case of a company, managerial finance or corporate finance is the task of providing the funds for the corporations' activities. It generally involves balancing risk and profitability. Long term funds would be provided by equity and long-term credit, often in form of bonds. These decisions lead to the company's capital structure. Short term funding or working capital is mostly provided by banks as line of credit.
On the bond market, borrowers package their debt in the form of bonds. The borrower receives the money it borrows by selling the bond, which includes a promise to repay the value of the bond with interest. The purchaser of a bond can resell the bond, so the actual recipient of interest payments can change over time. Bonds allow lenders to recoup the value of their loan by simply selling the bond.
Another business decision concerning finance is investment, or fund management. An investment is an acquisition of an asset in the hopes that it will maintain or increase its value. In investment management - in choosing a portfolio - one has to decide what, how much and when to invest. In doing so, one needs to
- Identify relevant objectives and constraints: institution or individual - goals - time horizon - risk aversion - tax considerations
- Identify the appropriate strategy: active vs passive - hedging strategy
- Measure the portfolio performance
Financial management is duplicate with the financial function of the accounting profession.
Finance of states
Country, state, county, city or municipality finance is called Public finance. It is concerned with
- Identification of required expenditure of a public sector entity
- Source(s) of that entity's revenue
- The budgeting process
- Debt issuance (municipal bonds) for public works projects
Main article Financial economics
Financial Economics is the branch of Economics studying the interrelation of financial variables, s.a. prices, interest rates and shares as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance.
Valuation - Determination of the fair value of an asset
- How risky is the asset? (identification of the asset appropriate discount rate)
- What cash flows will it produce? (discounting of relevant cash flows)
- How does the market price compare to similar assets? (relative valuation)
- Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
Main article Financial mathematics
Financial mathematics is the branch of applied mathematics concerned with the financial markets. Financial mathematics is the study of financial data with the tools of Mathematics, mainly statistics. Such data can be movements of securities - stocks and bonds etc. - and their relations. Another large subfield is insurance mathematics .
- For an in-depth finance glossary, see Glyn A. Holton's riskglossary
- For material covering three areas in finance - corporate finance, valuation and investment management, see Prof. Aswath Damodaran
- For articles on current corporate finance and investment issues, visit Oaktree Research, a financial education portal
- For illustrative (simpler) worked examples covering several of these topics see teachmefinance
- For introductory articles covering mathematical finance see quantnotes
- For introductory articles, a full glossary and links to resources on behavioral finance see the BF gallery
- An extensive resource for mathematical and quantitative finance at moneyscience.org