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FINANCE

Finance is a term for the management, creation, and study of money and investments. Specifically, it deals with the questions of how an individual, company or government acquires money – called capital in the context of a business – and how they spend or invest that money.[3] Finance is then often divided into the following broad categories: personal finance, corporate finance, and public finance.[1]

At the same time, and correspondingly, finance is about the overall “system”[1][2] i.e., the financial markets that allow the flow of money, via investments and other financial instruments, between and within these areas; this “flow” is facilitated by the financial services sector. Finance therefore refers to the study of the securities markets, including derivatives, and the institutions that serve as intermediaries to those markets, thus enabling the flow of money through the economy.[4]

A major focus within finance is thus investment management – called money management for individuals, and asset management for institutions – and finance then includes the associated activities of securities trading and stock broking, investment banking, financial engineering, and risk management. Fundamental to these areas is the valuation of assets such as stocks, bonds, loans, but also, by extension, entire companies.[5] Asset allocation, the mix of investments in the portfolio, is also fundamental here.

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. Similarly, although these areas overlap the financial function of the accounting profession, financial accounting is the reporting of historical financial information, whereas finance is forward-looking.

Given its wide scope, finance is studied in several academic disciplines, and, correspondingly, there are several related degrees and professional certifications that can lead to the field.

Contents
1 The financial system
2 Areas of finance
2.1 Personal finance
2.2 Corporate finance
2.3 Public finance
2.4 Investment management
2.5 Risk management
2.6 Quantitative finance
3 Financial theory
3.1 Managerial finance
3.2 Financial economics
3.3 Financial mathematics
3.4 Experimental finance
3.5 Behavioral finance
4 History of finance
5 Image gallery
6 See also
7 Notes
8 References
9 Further reading
10 External links
The financial system

The Federal Reserve monitors the U.S. financial system and works to ensure it supports a healthy, stable economy.

Bond issued by The Baltimore and Ohio Railroad. Bonds are a form of borrowing used by corporations to finance their operations.

Share certificate dated 1913 issued by the Radium Hill Company

The floor of the New York Stock Exchange in 1908

NYSE’s stock exchange traders floor c 1960; before the introduction of electronic readouts and computer screens

Chicago Board of Trade Corn Futures market, 1993

Oil traders, Houston, 2009
Main article: Financial system
See also: Financial services, financial market, and Circular flow of income
As above, the financial system consists of the flows of capital that take place between individuals (personal finance), governments (public finance), 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 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 or common stock). The owners of both bonds and stock may be institutional investors – financial institutions such as investment banks and pension funds – or private individuals, called private investors or retail investors.

The lending is often indirect, through a financial intermediary such as a bank, or via the purchase of notes or bonds (corporate bonds, government bonds, 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.[6][7][8] 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 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 banks. The investment banks find the initial investors and facilitate the listing of the securities, typically shares and bonds. Additionally, they facilitate the securities exchanges, 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, pension funds, wealth managers, and stock brokers, typically servicing retail investors (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” is inherently mathematical, and these institutions are then the major employers of “quants” (see below). In these institutions, risk management, regulatory 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.

Personal finance

Wealth management consultation – here the financial advisor counsels the client on an appropriate investment strategy
Main article: Personal finance
Personal finance is defined as “the mindful planning of monetary spending and saving, while also considering the possibility of future risk”.[9] Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, investing, and saving for retirement.[10] 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.[11] The following steps, as outlined by the Financial Planning Standards Board,[12] 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.[13]
Corporate finance

Founded in 1602, the Dutch East India Company (VOC), started off as a spice trader, “going public” in the same year, with the world’s first IPO.
Main articles: Corporate finance and Financial management
Further information: Strategic financial management
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 of all firms rather than corporations alone, the concepts are applicable to the financial problems of all firms,[2] and this area is then often referred to as “business finance”.

Typically “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 [14] three primary areas:

Capital budgeting: selecting which projects to invest in – here, accurately determining value is crucial, as judgements about asset values can be “make or break” [5]
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, 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 opposed to corporate financiers – focus more on the short term elements of profitability, cash flow, and “working capital management” (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 Financial management § Role and Financial analyst § Corporate and other.

Public finance

President George W. Bush, speaking on the Federal Budget in 2007, here requesting additional funds from Congress

2020 US Federal Revenues and Outlays
Main article: 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.[15] These long-term strategic periods typically encompass five or more years.[16] 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 projects.
Central banks, such as the Federal Reserve System banks in the United States and the 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.[17]

Development finance, which is related, concerns investment in economic development projects provided by a (quasi) governmental institution on a non-commercial basis; these projects would otherwise not be able to get financing. A public–private partnership 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

Share prices listed in a Korean Newspaper

“The excitement before the bubble burst” – viewing prices via ticker tape, shortly before the Wall Street Crash of 1929

Modern price-ticker. This infrastructure underpins contemporary exchanges, and allows, ultimately, for individual day trading, as well as wholesale computer-executed program trading and high-frequency trading.
Main article: Investment management
Investment management [18][19][2] 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, or REITs.

At the heart of investment management[2] is asset allocation – diversifying the exposure among these asset classes, and among individual securities within each asset class – as appropriate to the client’s investment policy, in turn, a function of risk profile, investment goals, and investment horizon (see Investor profile). Here:

Portfolio optimization is the process of selecting the best portfolio given the client’s objectives and constraints.
Fundamental analysis is the approach typically applied in valuing and evaluating the individual securities.
Overlaid is the portfolio manager’s investment style – broadly, active vs passive , value vs growth, and small cap vs. large cap – and investment strategy. 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 is managed using computer-based techniques (increasingly, machine learning) instead of human judgment. The actual trading also, is typically automated via sophisticated algorithms.

Risk management

Crowds gathering outside the New York Stock Exchange after the Wall Street Crash of 1929.

People queuing outside a Northern Rock branch in the United Kingdom to withdraw their savings during the financial crisis of 2007–2008.
Main article: Financial 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 [20][21] 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 is risk of default on a debt that may arise from a borrower failing to make required payments;
Market risk 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[2] 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’ credit policy and is often addressed through credit insurance and provisioning. Secondly, both disciplines share the goal of enhancing or at least preserving, the firm’s economic value, and in this context [22] overlaps also Enterprise risk management, typically the domain of strategic management. Here, businesses devote much time and effort to forecasting, analytics and performance monitoring. See also “ALM” and treasury management.

For banks and other wholesale institutions,[23] 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, and regulatory capital under Basel III. The calculations here are mathematically sophisticated, and within the domain of quantitative finance 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 “Risk Groups” here, whereas Front office risk teams provide risk “services” / “solutions” to customers.

Additional to diversification – the fundamental risk mitigant here – Investment Managers will apply various risk management techniques to their portfolios as appropriate:[2] these may relate to the portfolio as a whole or to individual stocks; bond portfolios are typically managed via cash flow matching or immunization. Re derivative portfolios (and positions), “the Greeks” is a vital risk management tool – it measures sensitivity to a small change in a given underlying parameter so that the portfolio can be rebalanced accordingly by including additional derivatives with offsetting characteristics.

Quantitative finance
Main article: Quantitative analysis (finance)
Quantitative finance – also referred to as “mathematical finance” – includes those finance activities where a sophisticated mathematical model is required,[24] and thus overlaps several of the above. As a specialized practice area, quantitative finance comprises primarily three sub-disciplines; the underlying theory and techniques are discussed in the next section:

Quantitative finance is often synonymous with financial engineering. This area generally underpins a bank’s customer-driven derivatives business — delivering bespo

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