Financial Success
Finance
is the study of how people allocate their assets over time under conditions of
certainty and uncertainty. A key point in finance, which affects decisions, is
the time value of money, which states that a unit of currency today is worth
more than the same unit of currency tomorrow. Finance aims to price assets based
on their risk level, and expected rate of return. Finance can be broken into
three different sub categories: public finance, corporate finance and personal
finance.
Personal
finance
Questions in
personal finance revolve around
How can people protect themselves against
unforeseen personal events, as well as those in the external economy?
How
can family assets best be transferred across generations (bequests and
inheritance)?
How does tax policy (tax subsidies and/or penalties) affect
personal financial decisions?
How does credit affect an individual's
financial standing?
How can one plan for a secure financial future in an
environment of economic instability?
Personal
financial decisions may involve paying for education, financing durable goods
such as real estate and cars, buying insurance, e.g. health and property
insurance, investing and saving for retirement.
Personal
financial decisions may also involve paying for a loan, or debt obligations. The
six key areas of personal financial planning, as suggested by the Financial
Planning Standards Board, are
1.Financial position: is concerned with
understanding the personal resources available by examining net worth and
household cash flow. Net worth is a person's balance sheet, calculated by adding
up all assets under that person's control, minus all liabilities of the
household, at one point in time. Household cash flow totals up all the expected
sources of income within a year, minus all expected expenses within the same
year. From this analysis, the financial planner can determine to what degree and
in what time the personal goals can be accomplished.
2.Adequate protection:
the analysis of how to protect a household from unforeseen risks. These risks
can be divided into liability, property, death, disability, health and long term
care. Some of these risks may be self-insurable, while most will require the
purchase of an insurance contract. Determining how much insurance to get, at the
most cost effective terms requires knowledge of the market for personal
insurance. Business owners, professionals, athletes and entertainers require
specialized insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benefits, utilizing insurance investment products
may be a critical piece of the overall investment planning.
3.Tax planning:
typically the income tax is the single largest expense in a household. Managing
taxes is not a question of if you will pay taxes, but when and how much.
Government gives many incentives in the form of tax deductions and credits,
which can be used to reduce the lifetime tax burden. Most modern governments use
a progressive tax. Typically, as one's income grows, a higher marginal rate of
tax must be paid.[citation needed] Understanding how to take advantage of the
myriad tax breaks when planning one's personal finances can make a significant
impact.
4.Investment and accumulation goals: planning how to accumulate
enough money for large purchases, and life events is what most people consider
to be financial planning. Major reasons to accumulate assets include, purchasing
a house or car, starting a business, paying for education expenses, and saving
for retirement. Achieving these goals requires projecting what they will cost,
and when you need to withdraw funds. A major risk to the household in achieving
their accumulation goal is the rate of price increases over time, or inflation.
Using net present value calculators, the financial planner will suggest a
combination of asset earmarking and regular savings to be invested in a variety
of investments. In order to overcome the rate of inflation, the investment
portfolio has to get a higher rate of return, which typically will subject the
portfolio to a number of risks. Managing these portfolio risks is most often
accomplished using asset allocation, which seeks to diversify investment risk
and opportunity. This asset allocation will prescribe a percentage allocation to
be invested in stocks, bonds, cash and alternative investments. The allocation
should also take into consideration the personal risk profile of every investor,
since risk attitudes vary from person to person.
5.Retirement planning is
the process of understanding how much it costs to live at retirement, and coming
up with a plan to distribute assets to meet any income shortfall. Methods for
retirement plan include taking advantage of government allowed structures to
manage tax liability including: individual (IRA) structures, or employer
sponsored retirement plans.
6.Estate planning involves planning for the
disposition of one's assets after death. Typically, there is a tax due to the
state or federal government at one's death. Avoiding these taxes means that more
of one's assets will be distributed to one's heirs. One can leave one's assets
to family, friends or charitable groups.
Corporate
finance [edit]
Main
article: Corporate finance
Managerial
or corporate finance is the task of providing the funds for a corporation's
activities (for small business, this is referred to as SME finance). Corporate
finance generally involves balancing risk and profitability, while attempting to
maximize an entity's wealth and the value of its stock, and generically entails
three interrelated decisions. In the first, "the investment decision",
management must decide which "projects" (if any) to undertake. The discipline of
capital budgeting is devoted to this question, and may employ standard business
valuation techniques or even extend to real options valuation; see Financial
modeling. The second, "the financing decision" relates to how these investments
are to be funded: capital here is provided by shareholders, in the form of
equity (privately or via an initial public offering), creditors, often in the
form of bonds, and the firm's operations (cash flow). Short-term funding or
working capital is mostly provided by banks extending a line of credit. The
balance between these elements forms the company's capital structure. The third,
"the dividend decision", requires management to determine whether any
unappropriated profit is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders, and if so in what
form. Short term financial management is often termed "working capital
management", and relates to cash-, inventory- and debtors management. These
areas often overlap with the firm's accounting function, however, financial
accounting is more concerned with the reporting of historical financial
information, while these financial decisions are directed toward the future of
the firm.
Another
business decision concerning finance is investment, or fund management. An
investment is an acquisition of an asset in the hope that it will maintain or
increase its value. In investment management – in choosing a portfolio – one has
to decide what, how much and when to invest. To do this, a company
must:
Identify relevant objectives and constraints: institution or
individual goals, time horizon, risk aversion and tax
considerations;
Identify the appropriate strategy: active versus passive
hedging strategy
Measure the portfolio performance
Financial
management is duplicate with the financial function of the Accounting
profession. However, financial accounting is more concerned with the reporting
of historical financial information, while the financial decision is directed
toward the future of the firm.
Financial
risk management, an element of corporate finance, is the practice of creating
and protecting economic value in a firm by using financial instruments to manage
exposure to risk, particularly credit risk and market risk. (Other risk types
include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks,
etc.) It focuses on when and how to hedge using financial instruments; in this
sense it overlaps with financial engineering. Similar to general risk
management, financial risk management requires identifying its sources,
measuring it (see: Risk measure: Well known risk measures), and formulating
plans to address these, and can be qualitative and quantitative. In the banking
sector worldwide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market
risks.
Financial
services
An entity
whose income exceeds its expenditure can lend or invest the excess income.
Though on the other hand, an entity whose income is less than its expenditure
can raise capital by borrowing or selling equity claims, decreasing its
expenses, or increasing its income. The lender can find a borrower, a financial
intermediary such as a bank, or buy notes or bonds in the bond market. The
lender receives interest, the borrower pays a higher interest than the lender
receives, and the financial intermediary earns the difference for arranging the
loan.
A bank
aggregates the activities of many borrowers and lenders. A bank accepts deposits
from lenders, on which it pays interest. The bank then lends these deposits to
borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate
their activity.
Finance is
used by individuals (personal finance), by governments (public finance), by
businesses (corporate finance) and by a wide variety of other organizations,
including schools and non-profit organizations. In general, the goals of each of
the above activities are achieved through the use of appropriate financial
instruments and methodologies, with consideration to their institutional
setting.
Finance is
one of the most important aspects of business management and includes decisions
related to the use and acquisition of funds for the
enterprise.
In corporate
finance, a company's capital structure is the total mix of financing methods it
uses to raise funds. One method is debt financing, which includes bank loans and
bond sales. Another method is equity financing - the sale of stock by a company
to investors, the original shareholders of a share. Ownership of a share gives
the shareholder certain contractual rights and powers, which typically include
the right to receive declared dividends and to vote the proxy on important
matters (e.g., board elections). The owners of both bonds and stock, may be
institutional investors - financial institutions such as investment banks and
pension funds or private individuals, called private investors or retail
investors.
Public
finance
Main
article: Public finance
Public
finance describes finance as related to sovereign states and sub-national
entities (states/provinces, counties, municipalities, etc.) and related public
entities (e.g. school districts) or agencies. It is concerned
with:
Identification of required expenditure of a public sector
entity
Source(s) of that entity's revenue
The budgeting process
Debt
issuance (municipal bonds) for public works projects
Central
banks, such as the Federal Reserve System banks in the United States and Bank of
England in the United Kingdom, are strong players in public finance, acting as
lenders of last resort as well as strong influences on monetary and credit
conditions in the economy.
Capital
Main
article: Financial capital
Capital, in
the financial sense, is the money that gives the business the power to buy goods
to be used in the production of other goods or the offering of a service. (The
capital has two types of resources Equity and Debt)
The
deployment of capital is decided by the budget. This may include the objective
of business, targets set, and results in financial terms, e.g., the target set
for sale, resulting cost, growth, required investment to achieve the planned
sales, and financing source for the investment.
A budget may
be long term or short term. Long term budgets have a time horizon of 5–10 years
giving a vision to the company; short term is an annual budget which is drawn to
control and operate in that particular year.
Budgets will
include proposed fixed asset requirements and how these expenditures will be
financed. Capital budgets are often adjusted annually and should be part of a
longer-term Capital Improvements Plan.
A cash
budget is also required. The working capital requirements of a business are
monitored at all times to ensure that there are sufficient funds available to
meet short-term expenses.
The cash
budget is basically a detailed plan that shows all expected sources and uses of
cash. The cash budget has the following six main sections:
1.Beginning Cash
Balance - contains the last period's closing cash balance.
2.Cash
collections - includes all expected cash receipts (all sources of cash for the
period considered, mainly sales)
3.Cash disbursements - lists all planned
cash outflows for the period, excluding interest payments on short-term loans,
which appear in the financing section. All expenses that do not affect cash flow
are excluded from this list (e.g. depreciation, amortization, etc.)
4.Cash
excess or deficiency - a function of the cash needs and cash available. Cash
needs are determined by the total cash disbursements plus the minimum cash
balance required by company policy. If total cash available is less than cash
needs, a deficiency exists.
5.Financing - discloses the planned borrowings
and repayments, including interest.
Financial
theory
Financial
economics
Main
article: Financial economics
Financial
economics is the branch of economics studying the interrelation of financial
variables, such as prices, interest rates and shares, as opposed to those
concerning the real economy. Financial economics concentrates on influences of
real economic variables on financial ones, in contrast to pure finance. It
centres on decision making under uncertainty in the context of the financial
markets, and the resultant economic and financial models. It essentially
explores how rational investors would apply decision theory to the problem of
investment. Here, the twin assumptions of rationality and market efficiency lead
to modern portfolio theory (the CAPM), and to the Black–Scholes theory for
option valuation; it further studies phenomena and models where these
assumptions do not hold, or are extended. "Financial economics", at least
formally, also considers investment under "certainty" (Fisher separation
theorem, "theory of investment value", Modigliani-Miller theorem) and hence also
contributes to corporate finance theory. Financial econometrics is the branch of
financial economics that uses econometric techniques to parameterize the
relationships suggested.
Although
closely related, the disciplines of economics and finance are distinctive. The
“economy” is a social institution that organizes a society’s production,
distribution, and consumption of goods and services,” all of which must be
financed.
Economists
make a number of abstract assumptions for purposes of their analyses and
predictions. They generally regard financial markets that function for the
financial system as an efficient mechanism (Efficient-market hypothesis).
Instead, financial markets are subject to human error and emotion. New research
discloses the mischaracterization of investment safety and measures of financial
products and markets so complex that their effects, especially under conditions
of uncertainty, are impossible to predict. The study of finance is subsumed
under economics as financial economics, but the scope, speed, power relations
and practices of the financial system can uplift or cripple whole economies and
the well-being of households, businesses and governing bodies within
them—sometimes in a single day.
Financial
mathematics
Main
article: Financial mathematics
Financial
mathematics is a field of applied mathematics, concerned with financial markets.
The subject has a close relationship with the discipline of financial economics,
which is concerned with much of the underlying theory. Generally, mathematical
finance will derive, and extend, the mathematical or numerical models suggested
by financial economics. In terms of practice, mathematical finance also overlaps
heavily with the field of computational finance (also known as financial
engineering). Arguably, these are largely synonymous, although the latter
focuses on application, while the former focuses on modeling and derivation
(see: Quantitative analyst). The field is largely focused on the modelling of
derivatives, although other important subfields include insurance mathematics
and quantitative portfolio problems. See Outline of finance: Mathematical tools;
Outline of finance: Derivatives pricing.
Experimental
finance
Main
article: Experimental finance
Experimental
finance aims to establish different market settings and environments to observe
experimentally 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 attempt to discover new principles
on which such theory can be extended. Research may proceed by conducting trading
simulations or by establishing and studying the behaviour of people in
artificial competitive market-like settings.
Behavioral
finance
Main
article: Behavioral finance
Behavioral
Finance studies how the psychology of investors or managers affects financial
decisions and markets. Behavioral finance has grown over the last few decades to
become central to finance.
Behavioral
finance includes such topics as:
1.Empirical studies that demonstrate
significant deviations from classical theories.
2.Models of how psychology
affects trading and prices
3.Forecasting based on these
methods.
4.Studies of experimental asset markets and use of models to
forecast experiments.
A strand of
behavioral finance has been dubbed Quantitative Behavioral Finance, which uses
mathematical and statistical methodology to understand behavioral biases in
conjunction with valuation. Some of this endeavor has been led by Gunduz
Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance
during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate
in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran).
Studies by Jeff Madura, Ray Sturm and others have demonstrated significant
behavioral effects in stocks and exchange traded funds. Among other topics,
quantitative behavioral finance studies behavioral effects together with the
non-classical assumption of the finiteness of
assets.
is the study of how people allocate their assets over time under conditions of
certainty and uncertainty. A key point in finance, which affects decisions, is
the time value of money, which states that a unit of currency today is worth
more than the same unit of currency tomorrow. Finance aims to price assets based
on their risk level, and expected rate of return. Finance can be broken into
three different sub categories: public finance, corporate finance and personal
finance.
Personal
finance
Questions in
personal finance revolve around
How can people protect themselves against
unforeseen personal events, as well as those in the external economy?
How
can family assets best be transferred across generations (bequests and
inheritance)?
How does tax policy (tax subsidies and/or penalties) affect
personal financial decisions?
How does credit affect an individual's
financial standing?
How can one plan for a secure financial future in an
environment of economic instability?
Personal
financial decisions may involve paying for education, financing durable goods
such as real estate and cars, buying insurance, e.g. health and property
insurance, investing and saving for retirement.
Personal
financial decisions may also involve paying for a loan, or debt obligations. The
six key areas of personal financial planning, as suggested by the Financial
Planning Standards Board, are
1.Financial position: is concerned with
understanding the personal resources available by examining net worth and
household cash flow. Net worth is a person's balance sheet, calculated by adding
up all assets under that person's control, minus all liabilities of the
household, at one point in time. Household cash flow totals up all the expected
sources of income within a year, minus all expected expenses within the same
year. From this analysis, the financial planner can determine to what degree and
in what time the personal goals can be accomplished.
2.Adequate protection:
the analysis of how to protect a household from unforeseen risks. These risks
can be divided into liability, property, death, disability, health and long term
care. Some of these risks may be self-insurable, while most will require the
purchase of an insurance contract. Determining how much insurance to get, at the
most cost effective terms requires knowledge of the market for personal
insurance. Business owners, professionals, athletes and entertainers require
specialized insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benefits, utilizing insurance investment products
may be a critical piece of the overall investment planning.
3.Tax planning:
typically the income tax is the single largest expense in a household. Managing
taxes is not a question of if you will pay taxes, but when and how much.
Government gives many incentives in the form of tax deductions and credits,
which can be used to reduce the lifetime tax burden. Most modern governments use
a progressive tax. Typically, as one's income grows, a higher marginal rate of
tax must be paid.[citation needed] Understanding how to take advantage of the
myriad tax breaks when planning one's personal finances can make a significant
impact.
4.Investment and accumulation goals: planning how to accumulate
enough money for large purchases, and life events is what most people consider
to be financial planning. Major reasons to accumulate assets include, purchasing
a house or car, starting a business, paying for education expenses, and saving
for retirement. Achieving these goals requires projecting what they will cost,
and when you need to withdraw funds. A major risk to the household in achieving
their accumulation goal is the rate of price increases over time, or inflation.
Using net present value calculators, the financial planner will suggest a
combination of asset earmarking and regular savings to be invested in a variety
of investments. In order to overcome the rate of inflation, the investment
portfolio has to get a higher rate of return, which typically will subject the
portfolio to a number of risks. Managing these portfolio risks is most often
accomplished using asset allocation, which seeks to diversify investment risk
and opportunity. This asset allocation will prescribe a percentage allocation to
be invested in stocks, bonds, cash and alternative investments. The allocation
should also take into consideration the personal risk profile of every investor,
since risk attitudes vary from person to person.
5.Retirement planning is
the process of understanding how much it costs to live at retirement, and coming
up with a plan to distribute assets to meet any income shortfall. Methods for
retirement plan include taking advantage of government allowed structures to
manage tax liability including: individual (IRA) structures, or employer
sponsored retirement plans.
6.Estate planning involves planning for the
disposition of one's assets after death. Typically, there is a tax due to the
state or federal government at one's death. Avoiding these taxes means that more
of one's assets will be distributed to one's heirs. One can leave one's assets
to family, friends or charitable groups.
Corporate
finance [edit]
Main
article: Corporate finance
Managerial
or corporate finance is the task of providing the funds for a corporation's
activities (for small business, this is referred to as SME finance). Corporate
finance generally involves balancing risk and profitability, while attempting to
maximize an entity's wealth and the value of its stock, and generically entails
three interrelated decisions. In the first, "the investment decision",
management must decide which "projects" (if any) to undertake. The discipline of
capital budgeting is devoted to this question, and may employ standard business
valuation techniques or even extend to real options valuation; see Financial
modeling. The second, "the financing decision" relates to how these investments
are to be funded: capital here is provided by shareholders, in the form of
equity (privately or via an initial public offering), creditors, often in the
form of bonds, and the firm's operations (cash flow). Short-term funding or
working capital is mostly provided by banks extending a line of credit. The
balance between these elements forms the company's capital structure. The third,
"the dividend decision", requires management to determine whether any
unappropriated profit is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders, and if so in what
form. Short term financial management is often termed "working capital
management", and relates to cash-, inventory- and debtors management. These
areas often overlap with the firm's accounting function, however, financial
accounting is more concerned with the reporting of historical financial
information, while these financial decisions are directed toward the future of
the firm.
Another
business decision concerning finance is investment, or fund management. An
investment is an acquisition of an asset in the hope that it will maintain or
increase its value. In investment management – in choosing a portfolio – one has
to decide what, how much and when to invest. To do this, a company
must:
Identify relevant objectives and constraints: institution or
individual goals, time horizon, risk aversion and tax
considerations;
Identify the appropriate strategy: active versus passive
hedging strategy
Measure the portfolio performance
Financial
management is duplicate with the financial function of the Accounting
profession. However, financial accounting is more concerned with the reporting
of historical financial information, while the financial decision is directed
toward the future of the firm.
Financial
risk management, an element of corporate finance, is the practice of creating
and protecting economic value in a firm by using financial instruments to manage
exposure to risk, particularly credit risk and market risk. (Other risk types
include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks,
etc.) It focuses on when and how to hedge using financial instruments; in this
sense it overlaps with financial engineering. Similar to general risk
management, financial risk management requires identifying its sources,
measuring it (see: Risk measure: Well known risk measures), and formulating
plans to address these, and can be qualitative and quantitative. In the banking
sector worldwide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market
risks.
Financial
services
An entity
whose income exceeds its expenditure can lend or invest the excess income.
Though on the other hand, an entity whose income is less than its expenditure
can raise capital by borrowing or selling equity claims, decreasing its
expenses, or increasing its income. The lender can find a borrower, a financial
intermediary such as a bank, or buy notes or bonds in the bond market. The
lender receives interest, the borrower pays a higher interest than the lender
receives, and the financial intermediary earns the difference for arranging the
loan.
A bank
aggregates the activities of many borrowers and lenders. A bank accepts deposits
from lenders, on which it pays interest. The bank then lends these deposits to
borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate
their activity.
Finance is
used by individuals (personal finance), by governments (public finance), by
businesses (corporate finance) and by a wide variety of other organizations,
including schools and non-profit organizations. In general, the goals of each of
the above activities are achieved through the use of appropriate financial
instruments and methodologies, with consideration to their institutional
setting.
Finance is
one of the most important aspects of business management and includes decisions
related to the use and acquisition of funds for the
enterprise.
In corporate
finance, a company's capital structure is the total mix of financing methods it
uses to raise funds. One method is debt financing, which includes bank loans and
bond sales. Another method is equity financing - the sale of stock by a company
to investors, the original shareholders of a share. Ownership of a share gives
the shareholder certain contractual rights and powers, which typically include
the right to receive declared dividends and to vote the proxy on important
matters (e.g., board elections). The owners of both bonds and stock, may be
institutional investors - financial institutions such as investment banks and
pension funds or private individuals, called private investors or retail
investors.
Public
finance
Main
article: Public finance
Public
finance describes finance as related to sovereign states and sub-national
entities (states/provinces, counties, municipalities, etc.) and related public
entities (e.g. school districts) or agencies. It is concerned
with:
Identification of required expenditure of a public sector
entity
Source(s) of that entity's revenue
The budgeting process
Debt
issuance (municipal bonds) for public works projects
Central
banks, such as the Federal Reserve System banks in the United States and Bank of
England in the United Kingdom, are strong players in public finance, acting as
lenders of last resort as well as strong influences on monetary and credit
conditions in the economy.
Capital
Main
article: Financial capital
Capital, in
the financial sense, is the money that gives the business the power to buy goods
to be used in the production of other goods or the offering of a service. (The
capital has two types of resources Equity and Debt)
The
deployment of capital is decided by the budget. This may include the objective
of business, targets set, and results in financial terms, e.g., the target set
for sale, resulting cost, growth, required investment to achieve the planned
sales, and financing source for the investment.
A budget may
be long term or short term. Long term budgets have a time horizon of 5–10 years
giving a vision to the company; short term is an annual budget which is drawn to
control and operate in that particular year.
Budgets will
include proposed fixed asset requirements and how these expenditures will be
financed. Capital budgets are often adjusted annually and should be part of a
longer-term Capital Improvements Plan.
A cash
budget is also required. The working capital requirements of a business are
monitored at all times to ensure that there are sufficient funds available to
meet short-term expenses.
The cash
budget is basically a detailed plan that shows all expected sources and uses of
cash. The cash budget has the following six main sections:
1.Beginning Cash
Balance - contains the last period's closing cash balance.
2.Cash
collections - includes all expected cash receipts (all sources of cash for the
period considered, mainly sales)
3.Cash disbursements - lists all planned
cash outflows for the period, excluding interest payments on short-term loans,
which appear in the financing section. All expenses that do not affect cash flow
are excluded from this list (e.g. depreciation, amortization, etc.)
4.Cash
excess or deficiency - a function of the cash needs and cash available. Cash
needs are determined by the total cash disbursements plus the minimum cash
balance required by company policy. If total cash available is less than cash
needs, a deficiency exists.
5.Financing - discloses the planned borrowings
and repayments, including interest.
Financial
theory
Financial
economics
Main
article: Financial economics
Financial
economics is the branch of economics studying the interrelation of financial
variables, such as prices, interest rates and shares, as opposed to those
concerning the real economy. Financial economics concentrates on influences of
real economic variables on financial ones, in contrast to pure finance. It
centres on decision making under uncertainty in the context of the financial
markets, and the resultant economic and financial models. It essentially
explores how rational investors would apply decision theory to the problem of
investment. Here, the twin assumptions of rationality and market efficiency lead
to modern portfolio theory (the CAPM), and to the Black–Scholes theory for
option valuation; it further studies phenomena and models where these
assumptions do not hold, or are extended. "Financial economics", at least
formally, also considers investment under "certainty" (Fisher separation
theorem, "theory of investment value", Modigliani-Miller theorem) and hence also
contributes to corporate finance theory. Financial econometrics is the branch of
financial economics that uses econometric techniques to parameterize the
relationships suggested.
Although
closely related, the disciplines of economics and finance are distinctive. The
“economy” is a social institution that organizes a society’s production,
distribution, and consumption of goods and services,” all of which must be
financed.
Economists
make a number of abstract assumptions for purposes of their analyses and
predictions. They generally regard financial markets that function for the
financial system as an efficient mechanism (Efficient-market hypothesis).
Instead, financial markets are subject to human error and emotion. New research
discloses the mischaracterization of investment safety and measures of financial
products and markets so complex that their effects, especially under conditions
of uncertainty, are impossible to predict. The study of finance is subsumed
under economics as financial economics, but the scope, speed, power relations
and practices of the financial system can uplift or cripple whole economies and
the well-being of households, businesses and governing bodies within
them—sometimes in a single day.
Financial
mathematics
Main
article: Financial mathematics
Financial
mathematics is a field of applied mathematics, concerned with financial markets.
The subject has a close relationship with the discipline of financial economics,
which is concerned with much of the underlying theory. Generally, mathematical
finance will derive, and extend, the mathematical or numerical models suggested
by financial economics. In terms of practice, mathematical finance also overlaps
heavily with the field of computational finance (also known as financial
engineering). Arguably, these are largely synonymous, although the latter
focuses on application, while the former focuses on modeling and derivation
(see: Quantitative analyst). The field is largely focused on the modelling of
derivatives, although other important subfields include insurance mathematics
and quantitative portfolio problems. See Outline of finance: Mathematical tools;
Outline of finance: Derivatives pricing.
Experimental
finance
Main
article: Experimental finance
Experimental
finance aims to establish different market settings and environments to observe
experimentally 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 attempt to discover new principles
on which such theory can be extended. Research may proceed by conducting trading
simulations or by establishing and studying the behaviour of people in
artificial competitive market-like settings.
Behavioral
finance
Main
article: Behavioral finance
Behavioral
Finance studies how the psychology of investors or managers affects financial
decisions and markets. Behavioral finance has grown over the last few decades to
become central to finance.
Behavioral
finance includes such topics as:
1.Empirical studies that demonstrate
significant deviations from classical theories.
2.Models of how psychology
affects trading and prices
3.Forecasting based on these
methods.
4.Studies of experimental asset markets and use of models to
forecast experiments.
A strand of
behavioral finance has been dubbed Quantitative Behavioral Finance, which uses
mathematical and statistical methodology to understand behavioral biases in
conjunction with valuation. Some of this endeavor has been led by Gunduz
Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance
during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate
in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran).
Studies by Jeff Madura, Ray Sturm and others have demonstrated significant
behavioral effects in stocks and exchange traded funds. Among other topics,
quantitative behavioral finance studies behavioral effects together with the
non-classical assumption of the finiteness of
assets.