Finance

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Jack Welch, an American business executive, author, and chemical engineer. He was chairman and CEO of General Electric between 1981 and 2001. During his tenure at GE, the company's value rose 4,000%. JackWelchApril2012.jpg
Jack Welch, an American business executive, author, and chemical engineer. He was chairman and CEO of General Electric between 1981 and 2001. During his tenure at GE, the company's value rose 4,000%.
Warren Buffett CEO & chairman of Berkshire Hathaway, American investor, business magnate, and philanthropist. He is considered by some to be one of the most successful investors in the world. Warren Buffett KU Visit.jpg
Warren Buffett CEO & chairman of Berkshire Hathaway, American investor, business magnate, and philanthropist. He is considered by some to be one of the most successful investors in the world.
James Harris Simons American mathematician, hedge fund manager, and philanthropist. He is known as a quantitative investor and in 1982 founded Renaissance Technologies, a private hedge fund based in East Setauket, NY. James Simons 2007.jpg
James Harris Simons American mathematician, hedge fund manager, and philanthropist. He is known as a quantitative investor and in 1982 founded Renaissance Technologies, a private hedge fund based in East Setauket, NY.
Professional qualifications in finance
Generalist Finance
Degrees Master of Science in Finance (MSF), Master of Finance (M.Fin), Master of Applied Finance (MAppFin), Master of Management / Master of Commerce / Master of Liberal Arts in Finance
Certifications Chartered Financial Analyst (CFA), Certified Treasury Professional (CTP), Certified Valuation Analyst (CVA), Certified Patent Valuation Analyst (CPVA), Chartered Business Valuator (CBV), Certified International Investment Analyst (CIIA), Financial Risk Manager (FRM), Professional Risk Manager (PRM), Association of Corporate Treasurers (ACT), Certified Market Analyst (CMA), Corporate Finance Qualification (CF), Chartered Alternative Investment Analyst (CAIA), Chartered Investment Manager (CIM), Financial Modeling & Valuation Analyst (FMVA).
Quantitative Finance Master of Financial Engineering (MSFE), Master of Quantitative Finance (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM), Certificate in Quantitative Finance (CQF)
Accountancy qualifications Qualified accountant Chartered Certified Accountant (ACCA, UK), Chartered Accountant (ACA – England & Wales; CA – Scotland and Commonwealth), Certified Public Accountant (CPA, US certification), ACMA/FCMA (Associate/Fellow Chartered Management Accountant; CIMA, UK). Certified Management Accountant (CMA; Institute of Management Accountants, US)
Non-statutory Chartered Cost Accountant CCA Designation from AAFM
Business qualifications Master of Business Administration (MBA), Master of Management (MM), Master of Commerce (M.Com), Master of Science in Management (MSM), Doctor of Business Administration (DBA)

Finance is the study of money and how it is used. Specifically, it deals with the questions of how an individual, company or government acquires the money needed - called capital in the company context - and how they then spend or invest that money. [1] Finance is, correspondingly, often split into three areas: personal finance, corporate finance and public finance. [2]

Contents

At the same time, finance is about the overall "system" [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. 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 & stock broking, investment banking, financial engineering, and risk management.

More abstractly, finance is concerned with the investment and deployment of assets and liabilities over "space and time": i.e. it is about performing valuation and asset allocation today, based on risk and uncertainty of future outcomes, incorporating the time value of money (determining the present value of these future values, "discounting", requires a risk-appropriate discount rate). As an academic field, finance theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics. Correspondingly, given its wide application, there are several related professional qualifications, that can lead to the field. As the debate to whether finance is an art or a science is still open, [3] there have been recent efforts to organize a list of unsolved problems in finance.

The financial system

An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though 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 (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.

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.

Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance) and by a wide variety of other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.

Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise. In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales. Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share. Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds   or private individuals, called private investors or retail investors.

Areas of finance

Personal finance

Personal finance [4] 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, e.g. health and property insurance, investing and saving for retirement. [5]

Personal finance may also involve paying for a loan, or debt obligations.

The following steps, as outlined by the Financial Planning Standards Board [6] , suggest that an individual will understand a potentially secure personal finance plan after:

Corporate finance

Corporate finance deals with the sources of funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. (Capital is of two types in the main, equity, and debt). Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. Short term financial management is often termed "working capital management", and relates to cash-, inventory- and debtors management. In the longer term, corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation.

Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial 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#Examples), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks. [8]

Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, whereas as discussed, financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders and increase their rate of return on the investments.

Public finance

Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term strategic perspective regarding investment decisions that affect public entities. [9] These long-term strategic periods usually encompass five or more years. [10] Public finance is primarily concerned with:

Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on monetary and credit conditions in the economy. [11]

Financial theory

Financial economics

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models.

It essentially explores how rational investors would apply risk and return to the problem of an investment policy. Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended.

"Financial economics", at least formally, also considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence also contributes to corporate finance theory.

Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.

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.

Financial mathematics

Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering ). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modeling and derivation (see: Quantitative analyst ). The field is largely focused on the modelling of derivatives, although other important subfields include insurance mathematics and quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.

Experimental finance

Experimental finance aims to establish different market settings and environments to observe experimentally 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, and 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, and the way that these people act or react, of people in artificial competitive market-like settings.

Behavioral finance

Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance. [12]

Behavioral finance includes such topics as:

  1. Empirical studies that demonstrate significant deviations from classical theories.
  2. Models of how psychology affects and impacts trading and prices
  3. Forecasting based on these methods.
  4. 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. Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001–2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm, and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

See also

Related Research Articles

Fundamental analysis analysis of a businesss financial statements

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

Capital market financial market for medium and long-term capital raising

A capital market is a financial market in which long-term debt or equity-backed securities are bought and sold. Capital markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. Financial regulators like Securities and Exchange Board of India (SEBI), Bank of England (BoE) and the U.S. Securities and Exchange Commission (SEC) oversee capital markets to protect investors against fraud, among other duties.

Financial market generic term for all markets in which trading takes place with capital

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, and precious metals.

Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based, i.e. retail, corporate, investment banking, etc.

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. It thus provides the theoretical underpin for much of "finance".

Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of an asset. For example, if someone owns a car worth $9,000 and owes $3,000 on the loan used to buy the car, then the difference of $6,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business entity. Selling equity in a business is an essential method for acquiring cash needed to start up and expand operations.

Capital asset pricing model CAPM

In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.

A financial analyst is a person who performs financial analysis for external or internal financial clients as a core part of the job. The role may alternatively be titled securities analyst, research analyst, equity analyst, investment analyst, or rating analyst.

Capital structure the way a corporation finances its assets through some combination of equity, debt, or hybrid securities

Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

In finance, leverage is any technique involving the use of debt rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples⁠ ⁠— hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on certain volatile shares.

In finance, a portfolio is a collection of investments held by an investment company, hedge fund, financial institution or individual.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.

In financial economics, asset pricing refers to a formal treatment and development of two main pricing principles, outlined below, together with the resultant models. There have been many models developed for different situations, but correspondingly, these stem from general equilibrium asset pricing or rational asset pricing, the latter corresponding to risk neutral pricing.

Financial modeling is the task of building an abstract representation of a real world financial situation. This is a mathematical model designed to represent the performance of a financial asset or portfolio of a business, project, or any other investment.

The following outline is provided as an overview of and topical guide to finance:

A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as US treasuries or gold. This is considered a sign of fear in the marketplace, as investors seek less risk in exchange for lower profits.

Quantitative analysis is the use of mathematical and statistical methods in finance. Those working in the field are quantitative analysts. Quants tend to specialize in specific areas which may include derivative structuring or pricing, risk management, algorithmic trading and investment management. The occupation is similar to those in industrial mathematics in other industries. The process usually consists of searching vast databases for patterns, such as correlations among liquid assets or price-movement patterns. The resulting strategies may involve high-frequency trading.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

References

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  4. "Personal Finance - Definition, Overview, Guide to Financial Planning". Corporate Finance Institute. Retrieved 2019-10-23.
  5. Publishing, Speedy (2015-05-25). Finance (Speedy Study Guides). Speedy Publishing LLC. ISBN   978-1-68185-667-4.
  6. "Financial Planning Standards Board", Financial Planning Competency Handbook, John Wiley & Sons, Ltd, 2019, pp. 709–735, doi:10.1002/9781119642497.ch80, ISBN   9781119642497
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  10. Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. pp. 53–54. ISBN   978-1439892237.
  11. 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 )
  12. Shefrin, Hersh (2002). Beyond greed and fear: Understanding behavioral finance and the psychology of investing. New York: Oxford University Press. p. ix. ISBN   978-0195304213 . Retrieved 8 May 2017.