The early history of finance parallels the early history of money, 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 was formed.
In the middle of the 20th century, finance emerged as a distinct academic discipline,[c] separate from economics.[1] The earliest doctoral programs in finance were established in the 1960s and 1970s.[2]
Today, finance is also widely studied through career-focused undergraduate and master's level programs.[3][4]
The financial system
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 CompanyNYSE's stock exchange traders floor c 1960, before the introduction of electronic readouts and computer screensChicago Board of TradeCorn Futures market, 1993Oil traders, Houston, 2009
As outlined, the financial system consists of the flows of capital that take place between individuals and households (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.[d]
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 run their operations.
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. (See Financial market participants.)
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).
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 refers to the practice of budgeting to ensure enough funds are available to meet basic needs, while ensuring there is only a reasonable level of risk to lose said capital. Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, investing, and saving for retirement.[9]
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,[10] 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 or a savings account;
Preparing for retirement or other long term expenses.[11]
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,[12]
and this area is then often referred to as "business finance".
Capital budgeting: selecting which projects to invest in—here, accurately determining value is crucial, as judgements about asset values can be "make or break".[14]
Dividend policy: the use of "excess" funds—these are to be reinvested in the business or returned to shareholders.
Financial managers—i.e. as distinct from 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 and Financial planning and analysis.)
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:[17]
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 1929A modern price-ticker. This infrastructure underpins contemporary exchanges, evidencing prices and related ticker symbols. The ticker symbol is represented by a unique set of characters used to identify the subject of the financial transaction.
Investment management[12] 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.
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.
Risk management here is discussed immediately below.
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 against financial risks, often by "hedging" exposure to these using financial instruments.
The focus is particularly on credit and market risk, and in banks, through regulatory capital, includes operational risk.
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:
Decision trees, a more sophisticated valuation-approach, sometimes applied to corporate finance "project" valuations (and a standard[28] in business school curricula); various scenarios are considered, and their discounted cash flows are probability weighted.
The tools 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.
Key aspects of managerial finance thus include:
Financial planning and forecasting
Capital budgeting
Capital structure
Working capital management
Risk management
Financial analysis and reporting.
The discussion, however, extends to business strategy more broadly, emphasizing alignment with the company's overall strategic objectives; and similarly incorporates the managerial perspectives of planning, directing, and controlling.
Financial economics
The "efficient frontier", a prototypical concept in portfolio optimization. Introduced in 1952, it remains "a mainstay of investing and finance".[30] An "efficient" portfolio, i.e. combination of assets, has the best possible expected return for its level of risk (represented by the standard deviation of return).Modigliani–Miller theorem, a foundational element of finance theory, introduced in 1958; it forms the basis for modern thinking on capital structure. Even if leverage (D/E) increases, the WACC (k0) stays constant.
Financial economics[31] is the branch of economics that studies the interrelation of financial variables, such as prices, interest rates and shares, as opposed to real economic variables, i.e. goods and services.
It thus centers on pricing, decision making, and risk management in the financial markets,[31][25] 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:[25]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:
The Black–Scholes formula for the value of a call option. Although lately its use is considered naive, it has underpinned the development of derivatives-theory, and financial mathematics more generally, since its introduction in 1973.[32]
As 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 main mathematical tools and techniques are, correspondingly:
The subject has a close relationship with financial economics, which, as outlined, 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[33] emphasizes the numerical methods applied here.
Experimental finance[36]
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 studies how the psychology of investors or managers affects financial decisions and markets[37]
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.[38]
Behavioral finance has grown over the last few decades to become an integral aspect of finance.[39]
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 involves applying quantum mechanical approaches to financial theory, providing novel methods and perspectives in the field.[40]Quantumfinance is an interdisciplinary field, in which theories and methods developed by quantum physicists and economists are applied to solve financial problems. It represents a branch known as econophysics. Although quantum computational methods have been around for quite some time and use the basic principles of physics to better understand the ways to implement and manage cash flows, it is mathematics that is actually important in this new scenario[41]
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.
The origin of finance can be traced to the beginning of state formation and trade during the Bronze Age. The earliest historical evidence of finance is dated to around 3000 BCE. Banking originated in West Asia, 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.[42] The Code of Hammurabi (1792–1750 BCE) included laws governing banking operations. The Babylonians were accustomed to charging interest at the rate of 20 percent per year. By 1200 BCE, cowrie shells were used as a form of money in China.
The use of coins as a means of representing money began in the years between 700 and 500 BCE.[43] Herodotus mentions the use of crude coins in Lydia around 687 BCE and, by 640 BCE, the Lydians had started to use coin money more widely and opened permanent retail shops.[44] Shortly after, cities in Classical Greece, such as Aegina, Athens, and Corinth, started minting their own coins between 595 and 570 BCE. During the Roman Republic, interest was outlawed by the Lex Genucia reforms in 342 BCE, though the provision went largely unenforced. Under Julius Caesar, a ceiling on interest rates of 12% was set, and much later under Justinian it was lowered even further to between 4% and 8%.[45]
The first exchange happened in Belgium in 1531.[46] Since then, popular exchanges such as the London Stock Exchange (founded in 1773) and the New York Stock Exchange (founded in 1793) were created.[47][48]
^
The following are definitions of finance as crafted by the authors indicated:
Fama and Miller: "The theory of finance is concerned with how individuals and firms allocate resources through time. In particular, it seeks to explain how solutions to the problems faced in allocating resources through time are facilitated by the existence of capital markets (which provide a means for individual economic agents to exchange resources to be available of different points In time) and of firms (which, by their production-investment decisions, provide a means for individuals to transform current resources physically into resources to be available in the future)."
Guthmann and Dougall: "Finance is concerned with the raising and administering of funds and with the relationships between private profit-seeking enterprise on the one hand and the groups which supply the funds on the other. These groups, which include investors and speculators — that is, capitalists or property owners — as well as those who advance short-term capital, place their money in the field of commerce and industry and in return expect a stream of income."
Drake and Fabozzi: "Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty."
F.W. Paish: "Finance may be defined as the position of money at the time it is wanted".
John J. Hampton: "The term finance can be defined as the management of the flows of money through an organisation, whether it will be a corporation, school, or bank or government agency".
Howard and Upton: "Finance may be defined as that administrative area or set of administrative functions in an organisation which relates with the arrangement of each debt and credit so that the organisation may have the means to carry out the objectives as satisfactorily as possible".
Pablo Fernandez: "Finance is a profession that requires interdisciplinary training and can help the managers of companies make sound decisions about financing, investment, continuity and other issues that affect the inflows and outflows of money, and the risk of the company. It also helps people and institutions invest and plan money-related issues wisely."
^Finance thus allows production and consumption in society to operate independently from each other. Without the use of financial allocation, production would have to happen at the same time and space as consumption. Through finance, distances in timespace between production and consumption are then posible.[5]
References
^Hayes, Adam. "Finance". Investopedia. Archived from the original on 2020-12-19. Retrieved 2022-08-03.
^Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov Accessed: 2010-01-16. (Archived by WebCite at Archived 2010-01-14 at the Wayback Machine)
^See for example III.A.3, in Carol Alexander, ed. (January 2005). The Professional Risk Managers' Handbook. PRMIA Publications. ISBN978-0976609704
^Bloomfield, Robert and Anderson, Alyssa. "Experimental finance"Archived 2016-03-04 at the Wayback Machine. In Baker, H. Kent, and Nofsinger, John R., eds. Behavioral finance: investors, corporations, and markets. Vol. 6. John Wiley & Sons, 2010. pp. 113-131. ISBN978-0470499115
^"Handelsbeurs" [Trade fair]. Visit Antwerp (in Dutch). Retrieved 2 September 2022. The 'Nieuwe Beurs' was built in 1531 because the 'Old Beurs' in Hofstraat had become too small. It was the first stock exchange ever built specifically for that purpose and later became the example for all stock exchange buildings in the world.
^"Our History". London Stock Exchange. Archived from the original on 2 September 2022. Retrieved 2 September 2022.
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