Finance is the study of, and practical applications associated with, money and money management. Banking and financial systems include credit and investments, assets and liabilities, from the public sector to the private sector; personal finance, financial instruments for debt and equity, and any other format that money takes on. In a nutshell, finance is pragmatic economics, economics of the real world, taken out of the theoretical; the process of making and managing money by investing, through the purchase and sale of assets and financial resources.
If the definition sounds wide and vague, that is because it is. It is extensive and covers just about anything that has monetary value. The expression, “Time is Money” indicates that the availability of money, has a value. Money has many forms from cash or greenbacks, to equity which is the value of shares issued by a company, an organization or a government entity.
The wide world of finance starts with economics, “the dismal science,” which is the study of the allocation of scarce resources. Money is used to assist with purchases and sales, and is a medium of exchange as well as a store of value.
By using credit, commerce can expand beyond current monetary limitations. Credit enables one party to obtain access to resources without full payment today. Instead, payment is made over time and is completed in the future. To enjoy access to resources now, the sum of all payments includes a premium payment, above and beyond. That is the cost of money in the future, also known as interest.
Debt is defined as owing money to another, having borrowed it, typically with the agreement to return in a stream of payments into the future. There are financial instruments that are designed in the form of debt or equity, where stocks are equity, owning a share of corporate stock means you own a piece of a company. Issuing debt, such as bonds and offering it publicly, once purchased means the issuer is indebted to the purchaser and promises to pay back the debt, plus interest, also known as the coupon rate.
Financial risk is defined relative to the uncertainty of the market, and sometimes in terms of a specific investment. In any definition of financial risk, there is the relationship between investment and return on investment. An individual will purchase a security based on the amount of risk he/she is willing to accept, balanced against the return on investment. An example might be the coupon rate, or interest rate, of a bond; the greater the return, the greater the risk. Bonds are rated, primarily, based on the credit worthiness of the issuer: the ability of the issuer to pay back the principal and the interest.
The risk of purchasing a bond is balanced against the promised return. If the issuer defaults, then the investor’s return is zero exacting a total loss.