Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, which is the study of production, distribution, and consumption of goods and services; the discipline of financial economics bridges the two.Financial activities take place in financial systems at various scopes; thus, the field can be roughly divided into personal, corporate, and public finance.[a]
A broad range of subfields within finance exists due to its wide scope. Asset, money, risk and investment management aim to maximize value and minimize volatility. Financial analysis is the viability, stability, and profitability assessment of an action or entity. In some cases, theories in finance can be tested using the scientific method, covered by experimental finance.
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Some fields are multidisciplinary, such as mathematical finance, financial law, financial economics, financial engineering and financial technology. These fields are the foundation of business and accounting.
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, separate from economics.[1] (The first academic journal, The Journal of Finance, began publication in 1946.) The earliest doctoral programs in finance were established in the 1960s and 1970s.[2]Finance is today also widely studied through career-focused undergraduate and master's level programs.[3][4]
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. [b]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.
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.
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:
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,[14] and this area is then often referred to as "business finance".
Typically, then, "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 [15] three primary areas:
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.[17] These long-term strategic periods typically encompass five or more years.[18] Public finance is primarily concerned with:[19]
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.[20]
Financial risk management is related to corporate finance[14] 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's 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[27] 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.
DCF valuation formula widely applied in business and finance, since articulated in 1938. Here, to get the value of the firm, its forecasted free cash flows are discounted to the present using the weighted average cost of capital for the discount factor.For share valuation investors use the related dividend discount model.
Financial theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics.Abstractly,[14][30] 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 the risk and uncertainty of future outcomes while appropriately incorporating the time value of money. Determining the present value of these future values, "discounting", must be at the risk-appropriate discount rate, in turn, a major focus of finance-theory.[31]As financial theory has roots in many disciplines, including mathematics, statistics, economics, physics, and psychology, it can be considered a mix of an art and science,[32] and there are ongoing related efforts to organize a list of unsolved problems in finance.
The discipline has two main areas of focus: [30]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:
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 [39] emphasizes the numerical methods applied here.
Experimental finance[42]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[43][44] 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.[45] Behavioral finance has grown over the last few decades to become an integral aspect of finance.[46]
Quantum finance is an interdisciplinary research field, applying theories and methods developed by quantum physicists and economists in order to solve problems in finance. It is a branch of econophysics.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. e24fc04721