what is finance 
finance is a term that addresses matters regarding the management creation and study of money and investments it involves the use of credit and debt securities and investment to finance current projects using future income flows finance is closely linked to the time value of money interest rates and other related topics because of this temporal aspect finance can be broadly divided into three categories other specific categories include behavioral finance which seeks to identify the cognitive emotional social and psychological reasons behind financial decisions mira norian investopediaunderstanding financefinance is typically broken down into three broad categories public finance corporate finance and personal finance public finance includes tax systems government expenditures budget procedures stabilization policies and instruments debt issues and other government concerns corporate finance involves managing assets liabilities revenues and debts for businesses personal finance defines all financial decisions and activities of an individual or household including budgeting insurance mortgage planning savings and retirement planning key finance termsasset an asset is something of value such as cash real estate or property a business may have current assets or fixed assets balance sheet a balance sheet is a document that shows a company s assets and liabilities subtract the liabilities from the assets to find the firm s net worth cash flow cash flow is the movement of money into and out of a business or household compound interest compound interest is calculated and added periodically unlike simple interest which is interest added to the principal one time this results in interest being charged not only on the principal but also on the interest that s already accrued equity equity means ownership stocks are called equities because each share represents a portion of ownership in the underlying corporation or entity liability a liability is a financial obligation such as debt liabilities can be current or long term liquidity liquidity refers to how easily an asset can be converted to cash real estate isn t a very liquid investment because it can take weeks months or even longer to sell profit profit is the money that s left over after expenses a profit and loss statement shows how much a business has earned or lost for a particular period history of financefinance arose as a study of theory and practice distinct from the field of economics in the 1940s and 1950s it began with the works of harry markowitz william f sharpe fischer black and myron scholes 123 particular realms of finance such as banking lending and investing have been around in some form since the dawn of civilization the financial transactions of the early sumerians were formalized in the babylonian code of hammurabi around 1800 bce this set of rules regulated ownership or rental of land employment of agricultural labor and credit 4 yes there were loans back then and yes interest was charged on them rates varied depending on whether you were borrowing grain or silver cowrie shells were used as a form of money in china by 1200 bce coined money was introduced in the first millennium bce king croesus of lydia which is now turkey was one of the first to strike and circulate gold coins around 564 bce hence the expression rich as croesus 5coins were stored in the basement of temples in ancient rome because priests and temple workers were considered to be the most honest and devout to safeguard assets temples also loaned money acting as financial centers of major cities 6belgium claims to be home to the first exchange with one in antwerp dating back to 1531 7 east india co became the first publicly traded company in the 1600s as it issued stock and paid dividends on proceeds from its voyages 8 the london stock exchange was created in 1773 and was followed by the new york stock exchange less than 20 years later the london exchange had been around since the 1570s as the royal exchange 910the earliest recorded bond dates back to 2400 bce it was a stone tablet that recorded debt obligations that guaranteed repayment of grain 11 governments began issuing debts to fund war efforts during the middle ages the bank of england was created to finance the british navy in the 1600s 12 the united states began issuing treasury bonds to support the revolutionary war nearly a century later 13the early practice of options is outlined through an anecdote by the philosopher thales in aristotle s 4th century philosophical work politics thales preemptively acquired the rights to all olive presses in chios and miletus believing that a great harvest of olives was on the horizon in the coming year both forward and options contracts were integrated into amsterdam s sophisticated clearing process by the mid 17th century 14compound interest is interest that s calculated not just on principal but on previously accrued interest it was known to ancient civilizations the babylonians had a phrase for interest on interest which basically defines the concept but it wasn t until medieval times that mathematicians started to analyze to show how invested sums could mount up one of the earliest and most important sources is the arithmetical manuscript written by leonardo fibonacci of pisa known as liber abaci in 1201 it gives examples comparing compound and simple interest luca pacioli s summa de arithmetica geometria proportioni et proportionalita was the first comprehensive treatise on bookkeeping and accountancy it was published in venice in 1494 15a book on accountancy and arithmetic written by william colson appeared in 1612 containing the earliest tables of compound interest written in english richard witt published his arithmeticall questions in london a year later in 1613 and compound interest was thoroughly accepted interest calculations were combined with age dependent survival rates to create the first life annuities in england and the netherlands toward the end of the 17th century types of financethe federal government helps prevent market failure by overseeing the allocation of resources distribution of income and stabilization of the economy regular funding for these programs is secured mostly through taxation 16 borrowing from banks insurance companies and other governments and earning dividends from its companies also helps finance the federal government state and local governments receive grants and aid from the federal government other sources of public finance include businesses obtain financing through a variety of means from equity investments to credit arrangements a firm might take out a loan from a bank or arrange for a line of credit acquiring and managing debt properly can help a company expand and become more profitable startups may receive capital from angel investors or venture capitalists in exchange for a percentage of ownership a company will issue shares on a stock exchange if it thrives and goes public such initial public offerings ipos bring a great influx of cash into a firm established companies may sell additional shares or issue corporate bonds to raise money businesses might also purchase dividend paying stocks blue chip bonds or interest bearing bank certificates of deposit cds they may buy other companies in an effort to boost revenue some examples of corporate financing include personal financial planning generally involves analyzing an individual s or a family s current financial position predicting short and long term needs and executing a plan to fulfill those needs within individual financial constraints personal finance depends largely on one s earnings living requirements and goals and desires matters of personal finance include but aren t limited to the securing of financial products like credit cards life and home insurance mortgages and retirement products personal banking products such as checking and savings accounts individual retirement accounts iras and 401 k plans are also considered a part of personal finance the most important aspects of personal finance include personal finance is a specialized field although forms of it have been taught in universities and schools as home economics or consumer economics since the early 20th century the field was initially disregarded by male economists because home economics appeared to be the purview of housewives economists have repeatedly stressed widespread education in matters of personal finance as integral to the macro performance of the overall national economy social finance typically refers to investments made in social enterprises including charitable organizations and some cooperatives these investments take the form of equity or debt financing in which the investor seeks both a financial reward and a social gain forms of social finance also include some segments of microfinance specifically loans to small business owners and entrepreneurs in less developed countries to enable their enterprises to grow lenders earn a return on their loans while simultaneously helping to improve individuals standards of living and to benefit the local society and economy social impact bonds also known as pay for success bonds or social benefit bonds are a specific type of instrument that acts as a contract with the public sector or local government repayment and return on investment are contingent upon the achievement of certain social outcomes and achievements there was a time when theoretical and empirical evidence seemed to suggest that conventional financial theories were reasonably successful at predicting and explaining certain types of economic events academics in the financial and economic realms nonetheless detected anomalies and behaviors that occurred in the real world but couldn t be explained by any available theories it became increasingly clear that conventional theories could explain certain idealized events but the real world was a great deal messier and more disorganized market participants frequently behave in ways that are irrational and difficult to predict according to those models academics began to turn to cognitive psychology to account for irrational and illogical behaviors that can t be explained by modern financial theory the field of behavioral science was born out of these efforts it seeks to explain our actions whereas modern finance looks to explain the actions of the idealized economic man homo economicus behavioral finance is a subfield of behavioral economics it proposes psychology based theories to explain financial anomalies such as severe rises or falls in stock prices the purpose is to identify and understand why people make certain financial choices it s assumed within behavioral finance that the information structure and the characteristics of market participants systematically influence individuals investment decisions as well as market outcomes daniel kahneman and amos tversky began to collaborate in the late 1960s and are considered by many to be the fathers of behavioral finance richard thaler joined them later and combined economics and finance with elements of psychology to develop concepts like mental accounting the endowment effect and other biases that have an impact on people s behavior behavioral finance encompasses many concepts but four are key mental accounting refers to the propensity for people to allocate money for specific purposes based on miscellaneous subjective criteria such as the source of the money and the intended use for each account the theory of mental accounting suggests that individuals are likely to assign separate functions to each asset group or account the result can be an illogical and even detrimental set of behaviors some people keep a special money jar set aside for a vacation or a new home while carrying substantial credit card debt at the same time herd behavior states that people tend to mimic the financial behaviors of the majority whether they re rational or irrational herd behavior is a set of decisions and actions that an individual wouldn t necessarily make on their own in many cases but which seem to have legitimacy because everyone s doing it herd behavior is often considered a major cause of financial panics and stock market crashes anchoring refers to attaching spending to a certain reference point or level even though it may have no logical relevance to the decision at hand one common example of anchoring is the conventional wisdom that a diamond engagement ring should cost about two months worth of salary another might be buying a stock that briefly rose from trading around 65 to hit 80 and then fell back to 65 out of a sense that it s now a bargain that could be true but it s more likely that the 80 figure was an anomaly and 65 is the true value of the shares high self rating refers to a person s tendency to rank themself better than others or higher than an average person an investor might think that they re an investment guru when their investments perform optimally blocking out the investments that are performing poorly high self rating goes hand in hand with overconfidence which reflects the tendency to overestimate or exaggerate one s ability to successfully perform a given task overconfidence can be harmful to an investor s ability to pick stocks a 1998 study by researcher terrance odean found that overconfident investors typically conducted more trades compared with their less confident counterparts and these trades produced yields significantly lower than the market 20scholars have argued that the 2000s have witnessed an unparalleled expansion of financialization or the role of finance in everyday business or life finance vs economicseconomics and finance are interrelated informing and influencing each other investors care about economic data because they also influence the markets to a great degree investors should avoid either or arguments regarding economics and finance both are important and have valid applications the focus of economics and especially macroeconomics tends to be a bigger picture in nature such as how a country region or market is performing economics can also focus on public policy the focus of finance is more individual company or industry specific microeconomics explains what to expect if certain conditions change on the industry firm or individual level microeconomics says that consumers will tend to buy fewer cars than before if a manufacturer raises the prices of cars the price of copper increases if a major copper mine collapses in south america because supply is restricted finance also focuses on how companies and investors evaluate risk and return economics has historically been more theoretical and finance more practical but the distinction has become much less pronounced since 2000 