The early history of finance parallels the earlyhistory of money, which isprehistoric. Ancient and medieval civilizations incorporated basic functions of finance, such as banking, trading and accounting, into their economies. In the late 19th century, theglobal financial system was formed.
In the middle of the 20th century, finance emerged as a distinct academic discipline,[b] separate from economics.[1] The earliest doctoral programs in finance were established in the 1960s and 1970s.[2] Today, finance is alsowidely studied through career-focused undergraduate andmaster's level programs.[3][4]
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 exchangetraders floor in 1963, 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.[c] 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 surplus with the aim of earning 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 sellinggovernment or corporate bonds; (ii) by a corporation sellingequity, also called stock or shares (which may take various forms:preferred stock orcommon stock). The owners of both bonds and stock may beinstitutional investors—financial institutions such as investment banks andpension funds—or private individuals, calledprivate investors or retail investors. (SeeFinancial market participants.)
Thelending is often indirect, through afinancial intermediary such as abank, or via the purchase of notes orbonds (corporate bonds,government bonds, or mutual bonds) in thebond market. The lender receives interest, theborrower 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. Banks accept deposits from individuals and businesses, paying interest on these funds. The bank then lends these deposits to borrowers, facilitating transactions between borrowers and lenders of various sizes and enabling efficient financial coordination. Investing typically entails the purchase ofstock, either individual securities or via amutual 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 theinvestment banks (whichfind the initial investors and facilitate the listing of the securities, typically shares and bonds), thesecurities exchanges (which allow their trade thereafter), and the various investment service providers (includingmutual funds,pension funds,wealth managers, andstock brokers, typically servicing retail investors).
As outlined, finance broadly comprises three areas: personal finance, corporate finance, and public finance. These, in turn, overlap and employ various activities and sub-disciplines—chieflyinvestments, risk management, andquantitative 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, financingdurable goods such asreal estate and cars, buyinginsurance, investing, and saving forretirement.[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 thecapital structure of corporations, and the tools and analysis used to allocate financial resources. While corporate finance is in principle different frommanagerial finance, which studies thefinancial 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, accuratelydetermining 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 theshort term elements of profitability, cash flow, and "working capital management" (inventory, credit anddebtors), which is concerned about the daily funding operations, and the goal is to maintain liquidity, minimize risk and maximize efficiency ensuring that the firm cansafely and profitably carry out its financialand 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 upcomingoperational expenses. (SeeFinancial management andFP&A.)
Public finance refers to the management of finances related to sovereign states, sub-national entities, and associated public agencies or bodies. 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 viaticker tape, shortly before theWall 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 andalternative 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, orreal estate investment trusts.
In a well-diversified portfolio, achievedinvestment 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 themarket cycle.
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 protectingcorporate value againstfinancial 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 wherea sophisticated mathematical model is required,[25] and thus overlaps several of the above.
As a specialized practice area, quantitative finance comprises primarily three sub-disciplines; the underlying theory and techniquesare discussed in the next section:
Decision trees, a more sophisticated valuation-approach, sometimes applied to corporate finance"project" valuations (and a standard[28] inbusiness school curricula); various scenarios are considered, and their discounted cash flows are probability weighted.
The tools addressed and developed relate in the main tomanagerial accounting andcorporate finance:the former allow management to better understand, and hence act on, financial information relating toprofitability 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:
Capital budgeting
Capital structure
Working capital management
Risk management
Financial analysis and reporting
The discussion, however, also extends to the broader field ofbusiness strategy, emphasizing the need for alignment with the overall strategic objectives of the company. It likewise incorporatesmanagerial perspectives related to planning, directing, and controlling.
The "efficient frontier", a prototypical concept in portfolio optimization. Introducedin 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 oncapital structure. Even ifleverage (D/E) increases, theweighted average cost of capital (k0) stays constant.
The discipline has two main areas of focus:[26]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 acall option. Although lately its use isconsidered naive, it has underpinned the development of derivatives-theory, and financial mathematics more generally, since its introduction in 1973.[32]
Asabove, in terms of practice, the field is referred to as quantitative finance and / or mathematical finance, and comprises primarily the three areas discussed.Themain mathematical tools and techniques are, correspondingly:
The subject is closely related to financial economics, which, as outlined, focuses on much of the underlying theory involved in financial mathematics: generally, financial mathematics will derive and extend themathematical models suggested.Computational finance is the branch of (applied)computer science that deals with problems of practical interest in finance, and especially[33] emphasizes thenumerical 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 study how well existing financial economics theories make accurate predictions and seek to validate them. They also aim to discover new principles to extend these theories for future financial decisions. This research often involves conducting trading simulations or observing human behavior in artificial, competitive, market-like environments.
Behavioral finance studies how thepsychology 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. Nowadays there is a need for more theory and testing of the effects of feelings on financial decisions. Especially, because now the time has come to move beyond behavioral finance to social finance, which studies the structure of social interactions, how financial ideas spread, and how social processes affect financial decisions and outcomes.[39][40]
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 dubbedquantitative 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.[41]Quantumfinance is an interdisciplinary field, in which theories and methods developed byquantum physicists and economists are applied to solve financial problems. It represents a branch known as econophysics. Althoughquantum 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.[42] Finance theory is heavily based onfinancial instrument pricing such asstock 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 ascomputational 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 theBronze Age. The earliest historical evidence of finance is dated to around 3000 BCE. Banking originated inWest 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, theSumerian city ofUruk inMesopotamia supported trade by lending as well as the use of interest. In Sumerian, "interest" wasmas, which translates to "calf". InGreece andEgypt, the words used for interest,tokos andms 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.[43] TheCode 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 inChina.
The use of coins as a means of representing money began in the years between 700 and 500 BCE.[44] Herodotus mentions the use of crude coins inLydia around 687 BCE and, by 640 BCE, the Lydians had started to use coin money more widely and opened permanent retail shops.[45] Shortly after, cities inClassical Greece, such asAegina,Athens, andCorinth, started minting their own coins between 595 and 570 BCE. During theRoman Republic, interest was outlawed by theLex Genucia reforms in 342 BCE, though the provision went largely unenforced. UnderJulius Caesar, a ceiling on interest rates of 12% was set, and much later underJustinian it was lowered even further to between 4% and 8%.[46]
^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]
^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 atArchived 2010-01-14 at theWayback Machine)
^See for example III.A.3, in Carol Alexander, ed. (2005).The Professional Risk Managers' Handbook. PRMIA Publications.ISBN978-0-9766097-0-4
^Bloomfield, Robert and Anderson, Alyssa."Experimental finance"Archived 2016-03-04 at theWayback 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.ISBN978-0-470-49911-5
^"Handelsbeurs" [Trade fair].Visit Antwerp (in Dutch). Retrieved2 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. Retrieved2 September 2022.
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