Finance - I

The Financial Environment

30 Dec 2024

---

What is finance?

Finance is the word we use to describe the management of money and various financial assets. One way to divide finance is into three broad categories:

• Institutions and markets. Financial institutions help to channel money from savers to borrowers. These include banks, insurance companies, and investment firms. Financial markets, on the other hand, provide a platform for facilitating the exchange of financial assets through buying and selling.
• Investments. Financial investments are activities that involve the analysis and sale of financial assets, for the purpose of generating returns. One example of an investment activity is portfolio diversification to reduce investment risk.
• Financial management. Financial management involves the planning, directing, and controlling of financial resources within an organization (or individual). Some activities that fall under financial management include budgeting, financial forecasting, and cash management.

Principles of finance

There are several principles that underpin the field of finance:

• Money has a time value. Money received now is worth more than money received some time in the future. This is because money now can be invested to earn interest, which means that it will grow over time.
• Higher returns are expected for taking on more risk. Investments can help generate returns, but these returns are not guaranteed. A general rule of thumb is that taking on higher risks is required to earn higher returns. For example, government bonds are considered less risky than stocks, which are less risky than cryptocurrencies. However, out of the three, cryptocurrencies have the potential to generate the highest returns (and losses).
• Diversifications can reduce risk. Since different financial assets have different risk-return profiles, holding a diversified portfolio can help reduce the overall risk of the portfolio. This is because the returns from different assets are not perfectly correlated. Thus, even if one asset underperforms, the losses from that asset can possibly be offset by gains from another asset.
• Financial markets are efficient. Since investors want to maximize returns, they will seek opportunities to exploit any mispricing or inefficiencies in the market. This, in turn, will lead to the quick correction of any mispricing. Thus, the prices of financial assets in the market are generally considered to be fair and reflect all available information. One corollary is that it is difficult to consistently outperform the market, because any information that you have (as a public investor) is likely already priced in.
• Principal-agent problem. This is the problem that arises when the interests of the principal (e.g. the owner) and the agent (e.g. the manager) are not aligned. One way to mitigate this problem is through the use of incentives to align both parties' interests, such as stock options or bonuses based on performance.
• Reputation matters. Reputation in finance is important because it reflects ethical behavior and trustworthiness. A financial institution with a good reputation can help attract investors and customers because they believe that the company will act fairly and responsibly.

The financial system

The goal of a financial system is to facilitate the flow of funds or financial capital from savings to investment. The financial system can be roughly divided into four components:

• Policy makers: responsible for passing laws and setting fiscal and monetary policies. These include various government institutions, such as Parliament, or the Ministry of Finance in Singapore.
• Monetary system: responsible for creating money and regulating the supply of money in the economy. This includes the central bank, which in Singapore is the Monetary Authority of Singapore (MAS).
• Financial institutions: responsible for channeling funds from savers to borrowers. These include various banks, insurance companies, and investment firms.
• Financial markets: responsible for facilitating the exchange of financial assets. These include various stock exchanges, bond markets, and cryptocurrency exchanges.

Some of the key processes in the financial system include:

• Creation of money: Money determines the amount of economic activity that can take place in an economy. Too much money can lead to inflation, whereas too little money can constrain economic growth.
• Transfer of money: The financial system helps to transfer money from savers to borrowers through various financial instruments and services. Some examples are check clearing, or electronic fund transfers.
• Lending and investing: Money that is accumulated in the financial system can be lent out to borrowers or invested in various financial assets. This helps to allocate capital to its most productive uses.
• Marketing of financial assets: Financial institutions and markets help to market various financial assets to investors. This includes activities such as underwriting, or the creation of new financial assets.
• Transfer of financial assets: In addition to creating new financial assets, the financial system also helps to transfer existing financial assets from one investor to another. This includes activities such as trading on the stock exchange.

Financial markets

Financial markets come in various forms. We can categorize them based on the features of the financial assets that are traded:

• Money markets are markets for short-term debt securities that mature in less than a year. These assets generally have low risk and low returns;
• Capital markets are markets for long-term debt and equity securities. These securities are used to finance long-term investments, such as purchasing a house, buying equipment, or building public infrastructure. Mortages and bonds are examples of capital market securities;
• Primary markets are markets where new securities are issued for the first time. This is where companies raise capital by selling new shares or bonds to investors;
• Secondary markets are markets where existing securities are bought and sold between investors. This is where investors can trade shares of stock or bonds with each other. The issuers do not receive any proceeds from transactions in the secondary market;

or based on the type of financial assets themselves:

• Debt securities markets are markets for debt securities, which are obligations to repay borrowed money. Some examples are bond markets, mortgage markets, and money markets;
• Equity securities markets are markets for equity securities, which represent ownership in a company. Stocks are issued either through a private placement or a public offering;
• Derivative securities markets are markets for derivative securities, which derive their value from an underlying asset. Some examples are options (a right to buy or sell), futures (an agreement to exchange an asset at a future date), and swaps (an agreement to exchange cash flows).
• Foreign exchange markets are markets for trading different currencies. There is a need for foreign exchange markets because different countries have different currencies, and businesses need to exchange one currency for another to conduct international trade.