What is Finance ? - Detail & Explanation
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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.
Finance is then often divided into the following broad categories: personal finance, corporate finance, and public finance.
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. 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.
The financial system
As above, the financial system consists of the flows of capital that take place between individuals, governments, and businesses.
"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:
by borrowing in the form of a loan, or by selling government or corporate bonds;
by a corporation selling equity, also called stock or shares.
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 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 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.
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".
In these institutions, risk management, regulatory capital, and compliance play major roles.
Areas of finance
As above, finance comprises, broadly, the three areas of personal finance, corporate finance, and public finance.
Although they are numerous, other areas and disciplines, such as investments, risk management, quantitative finance, and development finance typically overlap these; likewise, specific arrangements such as public–private partnerships.
Personal 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 goods 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 ;
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
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, 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"
These long-term strategic periods typically encompass five or more years. Public finance is primarily concerned with:
Identification of required expenditures of a public sector entity;
Source 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.
Investment management
Investment management 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.
