1.1 What Is Finance?
4 min read•june 18, 2024
Finance encompasses three main branches: corporate finance, , and financial institutions. Each branch plays a crucial role in managing money, from company decisions to individual investments. Understanding these areas helps make informed financial choices in personal and business settings.
Financial analysis tools like statements and analysis aid decision-making. The risk-return relationship is key, with higher risk often linked to higher potential returns. and models like CAPM help manage risk and assess investment opportunities.
Overview of Finance
Branches of finance
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- Corporate finance focuses on financial decisions within a company
- involves evaluating and selecting long-term investments (new factories, equipment)
- Capital structure determines the optimal mix of debt and equity financing (bonds, stocks)
- handles short-term assets and liabilities (inventory, accounts receivable)
- Investments focuses on the analysis and selection of investment opportunities
- constructs and manages a collection of investments (mutual funds, ETFs)
- evaluates individual securities, such as stocks (Apple, Amazon) and bonds (government, corporate)
- determines the optimal mix of asset classes in a portfolio (stocks, bonds, real estate)
- Financial institutions and markets focus on the role of financial intermediaries and the functioning of
- Banking accepts deposits and makes loans (checking accounts, mortgages)
- Insurance provides protection against financial losses (life insurance, car insurance)
- Securities markets facilitate the buying and selling of financial instruments (New York Stock Exchange, NASDAQ)
- Financial markets provide a platform for trading various financial instruments (stocks, bonds, derivatives)
Impact on decision-making
- Personal finance involves managing an individual's financial resources
- Budgeting manages personal income and expenses (tracking spending, creating a savings plan)
- Saving and investing sets aside money for future goals and grows wealth over time (retirement accounts, emergency funds)
- Borrowing uses credit responsibly to finance purchases or investments (student loans, credit cards)
- protects against financial losses through insurance and (health insurance, diversified investment portfolio)
- focuses on financial decisions within a company
- Financial planning forecasts future financial needs and creates plans to meet those needs ( projections, capital requirements)
- Investment decisions evaluate and select projects that generate value for the company (expanding production capacity, acquiring a competitor)
- Financing decisions choose the appropriate mix of debt and equity to fund operations and investments (issuing bonds, selling stock)
- Dividend policy determines how much of a company's earnings to distribute to shareholders (quarterly dividends, stock buybacks)
Financial Analysis and Decision-Making Tools
- provide a snapshot of a company's financial health and performance
- Cash flow analysis helps in understanding the inflows and outflows of money within a business
- concepts are used to compare the value of money at different points in time
- play a crucial role in determining the cost of borrowing and the return on investments
Risk and Return
Risk vs return relationship
- Risk-return tradeoff suggests that higher risk investments generally offer higher potential returns, while lower risk investments typically provide lower returns
- Stocks have higher risk and higher potential returns compared to bonds
- Government bonds have lower risk and lower returns compared to corporate bonds
- Measuring risk quantifies the uncertainty of investment returns
- is a statistical measure of the dispersion of returns around the mean (how far returns deviate from the average)
- is the square root of variance, used to quantify the volatility of returns (higher indicates greater risk)
- Diversification reduces risk by spreading investments across different asset classes, sectors, or geographies
- Holding a mix of stocks, bonds, and real estate in a portfolio
- Investing in companies from various industries (technology, healthcare, energy)
- Owning securities from different countries (United States, Europe, Asia)
- Diversification reduces unsystematic risk (company-specific or industry-specific risk) but cannot eliminate systematic risk (market risk)
- (CAPM) describes the relationship between systematic risk and expected return for a security
- Formula:
- represents the expected return of security i
- is the risk-free rate (return on a safe investment like government bonds)
- measures the of security i (sensitivity to market movements)
- is the expected return of the market (average return of all securities)
- Securities with higher values are more sensitive to market movements and have higher expected returns to compensate for the increased risk
- Formula:
Key Terms to Review (49)
401k plans: 401(k) plans are employer-sponsored retirement savings plans that allow employees to save and invest a portion of their paycheck before taxes are taken out. These contributions grow tax-deferred until they are withdrawn during retirement.
Asset Allocation: Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash, in order to manage risk and optimize returns. It is a fundamental concept in finance that helps investors achieve their financial goals by balancing the risks and rewards associated with different investment options.
Banking Act of 1935: The Banking Act of 1935 was a significant piece of legislation in the United States that restructured the Federal Reserve System. It aimed to enhance financial stability and increase the power of federal regulators over the banking industry.
Beta: Beta measures the volatility or systematic risk of a security or portfolio relative to the overall market. A beta greater than 1 indicates more volatility than the market, while a beta less than 1 indicates less volatility.
Beta: Beta is a measure of the volatility or systematic risk of a financial asset or portfolio in relation to the overall market. It represents the sensitivity of an asset's returns to changes in the market's returns, providing a quantitative assessment of an investment's risk profile.
Billions: Billions represent a numerical value of 1,000 million, often used in finance to denote large sums of money or valuations. In financial contexts, billions are frequently seen in corporate finance, national budgets, and market capitalizations.
Business finance: Business finance involves the management, creation, and study of money and investments for a business. It encompasses activities like budgeting, investing, borrowing, forecasting, and analyzing financial performance.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It provides a framework for understanding how the market values an asset based on its systematic risk, which is measured by the asset's beta. CAPM is a fundamental concept in finance that is widely used in investment analysis, portfolio management, and corporate finance decision-making.
Capital Budgeting: Capital budgeting is the process of evaluating and selecting long-term investments or projects that are expected to generate returns for a business over multiple years. It involves analyzing the costs, risks, and potential benefits of various investment options to determine the most advantageous use of a company's limited financial resources.
Cash flow: Cash flow is the net amount of cash being transferred into and out of a business. It represents the company's operating, investing, and financing activities over a specific period.
Cash Flow: Cash flow refers to the net amount of cash and cash-equivalents moving in and out of a business or an individual's possession over a given period of time. It is a crucial measure of financial health and performance, as it reflects the ability to generate and manage the inflow and outflow of cash necessary for operations, investments, and financing activities.
Diversifiable risk: Diversifiable risk, also known as unsystematic risk, is the portion of an investment's risk that can be reduced or eliminated through diversification. It is specific to a company or industry and not correlated with the market as a whole.
Diversification: Diversification involves spreading investments across various financial assets to reduce risk. It aims to minimize the impact of any single asset's poor performance on an overall investment portfolio.
Diversification: Diversification is the practice of investing in a variety of assets to reduce the overall risk of a portfolio. It involves spreading investments across different asset classes, industries, and geographic regions to minimize the impact of any single investment's performance on the overall portfolio.
Exchange-traded funds (ETFs): Exchange-Traded Funds (ETFs) are investment funds traded on stock exchanges, much like stocks. They hold a diversified portfolio of assets such as stocks, bonds, or commodities.
Financial Industry Regulatory Authority (FINRA): The Financial Industry Regulatory Authority (FINRA) is a non-governmental organization that regulates member brokerage firms and exchange markets. It aims to ensure market integrity and protect investors by enforcing rules governing the financial industry in the United States.
Financial Markets: Financial markets are the platforms where the trading of various financial instruments, such as stocks, bonds, currencies, and derivatives, takes place. These markets facilitate the efficient allocation of capital, risk management, and price discovery, which are essential for the functioning of the economy.
Financial markets and institutions: Financial markets and institutions refer to venues and entities that facilitate the exchange of financial assets and the provision of financial services. They play a crucial role in ensuring liquidity, price discovery, and efficient allocation of resources in an economy.
Financial Statements: Financial statements are the primary means of communicating a company's financial information to internal and external stakeholders. They provide a comprehensive overview of a business's financial position, performance, and cash flows, enabling informed decision-making.
Glass-Steagall Act (1933): The Glass-Steagall Act of 1933 was a law that separated commercial banking from investment banking activities in the United States. It aimed to reduce conflicts of interest and prevent another financial crisis like the Great Depression.
Individual retirement accounts (IRAs): Individual Retirement Accounts (IRAs) are investment tools used by individuals to earmark funds for retirement savings. They offer potential tax advantages, making them a popular choice for long-term financial planning.
Inflation risk: Inflation risk is the potential for the value of an investment to be eroded due to rising prices in the economy. It affects the real return on investments, making future cash flows worth less in today's terms.
Interest Rates: Interest rates refer to the cost of borrowing money or the return on saving and investing. They are a fundamental concept in finance that impact both personal and business decisions related to the time value of money.
Investments: Investments are assets or items acquired with the goal of generating income or appreciation. They can include stocks, bonds, real estate, and other financial instruments.
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a crucial concept in finance that encompasses the ability of individuals, businesses, and markets to readily access and transact with available funds or assets.
MasterCard: MasterCard is a global payments technology company that connects consumers, financial institutions, merchants, governments, and businesses worldwide. It facilitates electronic payments through its branded credit and debit cards.
Non-diversifiable risk: Non-diversifiable risk, also known as systematic risk, is the inherent risk that affects the entire market or a broad range of assets. It cannot be eliminated through diversification.
PayPal: PayPal is an online payment platform that allows individuals and businesses to transfer funds electronically. It offers a secure way to make payments, send money, and accept payments without revealing financial information.
Political risk: Political risk is the potential for losses or other adverse impacts on business operations due to political instability or changes in government policy. It affects investments, corporate strategies, and financial returns in international markets.
Portfolio Management: Portfolio management is the process of selecting, monitoring, and optimizing a collection of investments to meet an investor's financial goals and risk tolerance. It involves constructing, monitoring, and adjusting a portfolio of assets to achieve the desired balance between risk and return.
Real interest rates: Real interest rates are the rates of interest an investor expects to receive after allowing for inflation. It is calculated by subtracting the inflation rate from the nominal interest rate.
Risk Management: Risk management is the process of identifying, assessing, and controlling potential risks in order to minimize their negative impact on an organization or individual. It is a crucial aspect of finance, as it helps ensure the stability and sustainability of financial operations, investments, and decision-making.
Risk Management Association (RMA): Risk Management Association (RMA) is a professional organization dedicated to enhancing risk management practices in the financial services industry. It provides resources, education, and networking opportunities for professionals involved in risk management, including credit and operational risk.
Securities Act of 1933: The Securities Act of 1933 is a federal law enacted to ensure greater transparency in financial statements and to establish laws against misrepresentation and fraudulent activities in the securities markets. Its primary goal is to protect investors by requiring issuers of securities to provide full and fair disclosure.
Securities Exchange Act of 1934: The Securities Exchange Act of 1934 is a U.S. federal law that governs the trading of securities such as stocks and bonds in the secondary market. It established the Securities and Exchange Commission (SEC) to enforce federal securities laws and regulate the securities industry.
Securities Investor Protection Corporation (SIPC): The Securities Investor Protection Corporation (SIPC) is a non-profit corporation created by Congress to protect investors if their brokerage firm fails. It provides limited insurance coverage for securities and cash held in a brokerage account.
Security Analysis: Security analysis is the process of evaluating the intrinsic value of a financial security, such as a stock or bond, to determine its investment potential and make informed investment decisions. It involves a comprehensive examination of a company's financial statements, industry trends, and other relevant factors to assess the security's risk and return profile.
Solvency: Solvency refers to a company's ability to meet its long-term financial obligations and debt commitments. It is a measure of a firm's financial health and its capacity to continue operating and growing its business without the risk of defaulting on its debts.
Standard deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of data values. It is used to assess the risk and volatility of an investment's returns in finance.
Standard Deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion of a set of data values around the mean or average. It provides a way to understand how spread out a group of numbers is from the central tendency.
Stock market crash of 1929: The stock market crash of 1929 was a severe downturn in equity prices that marked the beginning of the Great Depression. It occurred over several days, most notably on October 24 (Black Thursday) and October 29 (Black Tuesday).
The Great Recession of 2007–2009: The Great Recession of 2007–2009 was a severe global economic downturn that began with the collapse of the housing bubble in the United States. It led to widespread financial instability, massive job losses, and significant declines in consumer wealth and economic activity.
Time Value of Money: The time value of money is a fundamental concept in finance that recognizes the difference in value between a sum of money available today and the same sum available at a future point in time. It is based on the principle that money available at the present time is worth more than the identical sum in the future due to its potential to earn interest or be invested to generate a return.
Time value of money (TVM): Time Value of Money (TVM) is the concept that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle underlines why receiving money today is preferable to receiving it later.
Variance: Variance is a statistical measure that quantifies the amount of variation or dispersion of a set of data values from the mean or expected value. It is a fundamental concept in finance that is closely related to the assessment of risk and return for individual assets and portfolios.
Venmo: Venmo is a mobile payment service that allows users to transfer money to one another using a mobile phone app. It is commonly used for peer-to-peer transactions, such as splitting bills or paying back friends.
Wall Street: Wall Street is a major financial district in New York City, known for being the home of the New York Stock Exchange (NYSE) and many major banks and investment firms. It is often used as a metonym for the American financial markets and investment community.
Working capital management: Working capital management involves managing a company's short-term assets and liabilities to ensure it has sufficient liquidity to meet its operational needs. Effective working capital management helps maintain smooth business operations and improves financial stability.
Working Capital Management: Working capital management is the process of ensuring a business has sufficient funds to cover its short-term operational expenses and obligations. It involves the optimization of a company's current assets and current liabilities to maintain liquidity and operational efficiency.