Whether you're a wage earner with bills to pay or still in school - with all those joyous perks of adulthood yet ahead of you, you know at least a little bit about finance. It revolves around three foundational elements; money, assets and currency. Finance looks at all the ways people, corporations and governments use money and the ways they gain their money.
Finance looks at the various types of assets and what can be done with them. The study of finance extends into the theoretical realm as well, with several disciplines, including those closely related to economics. In this article, we answer specific questions about certain aspects of finance:
- What are financial systems?
- What are financial instruments?
- How is finance managed?
- What are the scopes of activity in finance?
- What is Financial Theory?
Before we jump into our topic, though, let's clarify one very important component of finance: money. Not the stuff you have in your pocket or wish you had more of; that's currency. Money is assets: stocks, bonds, property you own... the sort of thing monied people have. They're not called monied because they have a lot of cash, by the way; some monied people are cash-poor. With that clear, on with our topic.
Finance: Scopes of Activity
Money may make the world go 'round, as the old saying goes, but it doesn't do so on its own. It gets pushed this way and that, and encounters challenging situations at every turn. It doesn't work in the same way for every entity with dealings in finance, either.
Personal finance covers how individuals and families undertake financial activity. Budgeting, spending and saving; but also protecting their assets through insurance, investing for their retirement and, through it all, safeguarding against risk as best they can. All of these expenses must be balanced with their income but, as is so often the case these days, they may have to borrow against some of their other assets. They might head to a bank to apply for a loan; maybe a corporate bank.
Those banks are owned by corporations; they have a different focus than individuals do. Corporate finance is all about increasing their firms' value for their shareholders. It's not easy to balance their duty to their shareholders - increasing the company's value when they need capital to finance new growth opportunities. For them, growth falls under capital budgeting and paying for ordinary operational expenses comes out of what they call working capital.
Often, corporations get substantial boosts from public finance. The government subsidises wealthy corporations to convince them to add more jobs and to stay put. A company that pulls up stakes and relocates can devastate the financial systems it had formerly been a part of, to say nothing of the local economy. So, it's in public finance's best interests to lend to or invest in corporations. These financial scopes of activity are all intertwined and they all depend on one another.
Understanding Financial Instruments
We've mentioned a few financial instruments so far: currency, loans, stocks and investments. How much longer can the list get? That's a trick question. The simplest definition of financial instruments is 'contracts'. Any monetary contract is a financial instrument... but now, we're back to square one. What is a monetary contract?
These contracts establish two things: who owns the asset and who has the right to receive the instrument(s) listed in the contract. Cash instruments are the easiest to understand. If you take out a loan from the bank, you sign a contract stating you will pay that money back at a certain interest rate usually dictated by the markets as much as your bona fides. That contract is a financial instrument.
The list of derivative instruments is longer but not much harder to understand. Securities such as bonds and bond futures count among the long-term asset classes that take more than a year to mature. Certificates of Deposit or CDs and commercial paper are short-term assets settled in under a year's time. To clarify, commercial paper is essentially an IOU (I owe you) that corporations write to themselves when they're a bit short of working capital.
We often hear about futures in connection with finance and investment. Futures are very flexible; they entail signing a contract that states you will buy a specified amount of some asset at a set point in the future. If you'd rather hedge your bets - maybe you're worried that an asset won't be as valuable in a few months, you can sign an options contract. it will give you the option to buy that asset on or by a set date but you won't be in breach of contract if you don't. The more you know about financial instruments, the easier this all is to understand.
Explaining Financial Systems
Like any good reporter would, we've covered 'who' and 'what' on our way to explaining 'where' - for our purposes, where financial transactions take place. Banks and non-banking financial institutions such as credit unions and building societies are the most publicly accessible parts of financial systems. Another main component is financial markets - stock markets and the like, where exchanges take place.
Financial services outlets such as brokerage firms, insurance agents and any company that manages assets provide access to financial systems as well. Private equity firms are getting a lot of press for their particularly aggressive investment strategies which include leveraged buyouts. They are investment management companies that specialise in growing private equity for established companies as well as startups.
The final component of a financial system is its raison d'être: assets. Obviously, they're not a 'where', unless we think of it as 'having assets assures your place in society'. But that's beside the point. Assets are the 'products' traded in the markets. Securities, options, futures, stocks and other financial instruments underpin every action in financial market systems.
It's all fine and well to sell investors a hot stock or a bet on commodities futures but the more intensive work is after-the-sale service. Brokers and investment managers don't simply hand their clients shiny new piles of investments and call it 'job done!'. Their work also involves managing those assets: guarding against risk and calculating new ways to maximise returns.
In finance, risk is a twofold proposition. On one hand, there's the risk of an investment performing poorly. A company's stock might tank due to market fluctuations or another external event, or it could suffer a valuation risk, meaning its worth may have been overestimated at the time of sale. Pump and dump schemes exemplify this type of risk.
Operational risk is the other side of the risk coin. Every business expects some loss but when the losses exceed expectations, the company's overall value will likely drop. Operational risk can be internal - systems failures, supply and personnel shortages and so on, or external. Operational risk has far greater impacts than, say, credit risks or liquidity risks because they might destabilise entire markets. The 2008 financial crash stands as the most egregious example of operational risk to date. Those tasked with managing finance in those firms simply ignored all the warning signs of the impending meltdown.
A Note on Financial Theory
Most of us accept our financial assets, liabilities and constraints without too much thought of how our individual circumstances and financial decisions play in the wider world of finance. Right now, China provides us with the clearest look at how personal decisions can impact a nation's economy. The Chinese are prudent; experience has taught them that saving money hedges against all future risks. That's an effective strategy for personal finance but low levels of consumption do nothing to stimulate the economy or provoke growth.
The Chinese economy is still healthier than many other countries but what's happening there now, particularly in the property sector, has set every financial theorist to modelling possible outcomes, trying to predict this event's fallout. Experimental finance is a branch of financial theory that explores 'what if?' questions. To model possible outcomes of the Chinese property event, these researchers start with the known variables - minimal personal spending, investors hedging and government financial actions, and then add variables to predict outcomes under those hypothetical conditions.
China's property market catastrophe is due, in part, to risky managerial finance. Property developers made decisions without considering - or, perhaps not heeding advice from finance managers that would have made those developments sound ventures. Managerial finance is the branch of financial theory that looks at company operations. It studies how they make their decisions, and how those decisions protect or harm the corporation's financial profile.
Finance and economics are often thought to be synonymous, especially as many financial theories overlap with economic ones. However, as noted in our full-length article on the topic, the two disciplines are only closely related. Financial theorists study assets, currency and their movement while economic theorists focus on the production and distribution of economic goods, and how they're consumed.
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