The Financial Environment
Chapters 1, Melicher & Norton, Introduction to Finance, 17th Edition
1 June 2024
The Financial Environment
Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial assets. People with excess funds want to lend their money to earn a return, while people who need funds want to borrow money to finance their operations. The financial system solves both problems by providing efficient ways to channel financial resources from lenders to borrowers. Lenders either lend directly to borrowers, by buying various financial assets, or by relying on financial institutions to lend or invest the money on their behalf.
One goal of studying finance is to make informed decisions in our personal and professional lives. Very often, we need to make decisions about whether to spend money now, or save it for the future. Finance provides the tools to help us make these decisions.
There are several key principles in finance:
Money now is always worth more than money promised in the future, because money now can be invested to earn a return. However, there is a trade-off between risk and return: higher expected returns are associated with higher risk because there is always uncertainty in the outcome or payoff of an investment in the future. Some risk (not all) can be removed by diversifying investments across different assets or securities. These assets are traded in financial markets. It is generally assumed that financial markets are information efficient, meaning that the prices of financial assets always reflect all available information. When new information becomes available, investors quickly buy or sell assets to take advantage of the new information, and prices adjust accordingly. People invest their money either directly, or indirectly by hiring a financial manager to invest on their behalf. However, the goals of managers and owners do not always align, some managers may be more interested in their own compensation than that of the owners. Finally, reputation is a key factor in finance, because it is a reflection of an individual's ethical behavior, and serves as a signal of trustworthiness.
The financial system channels financial resources from lenders to borrowers. There are four components in the financial system:
Financial markets can be classified in several ways. Money markets deal in short term debt securities that mature in less than a year, while capital markets deal in longer term securities. Primary markets are where new securities are first issued, while secondary markets are where existing securities are traded. Markets may also be classified in terms of the types of products that are traded:
Debt securities are obligations made by the issuer or borrower to pay the owner or lender a specified amount of money at a specified time. When a corporation or government issues a debt security, and it is sold to an investor, the investor becomes a creditor of the corporation or government, and is entitled to receive interest and principle payments. Debt securities include money market securities, bonds, and mortgages.
Equity securities represent ownership in a corporation. When a corporation issues an equity security, and it is sold to an investor, the investor becomes a part owner of the corporation, and is entitled to receive dividends and capital gains on their equity investment. Equity securities include common and preferred stocks. Both are issued in primary markets through private placements or public offerings, and are traded in secondary markets through stock exchanges.
Derivative securities derive their value from the value of an underlying debt or equity security. Derivatives include options, futures, and swaps. For example, an option is a contract that gives the holder the right to buy or sell an asset at a specified price within a specified time period. Derivatives are used to hedge risk, speculate on future prices, and to arbitrage between different markets.
Investors can also buy and sell financial assets in foreign countries. However, different countries often have different currencies. A foreign exchange market is where different foreign currencies are traded.