Every day we hear about something related to finance. People have stereotypes about the financial world, without understanding what is meant by the word finance. In our first article, we hope to give you a first grasp of what stands behind the seven letters of finance. In order to do so, we will introduce basic key concepts: First we’ll introduce the creation, the supply and the time value of money. Then we’ll talk about assets, liabilities, equities and balance sheet. Finally we will give you a broad definition of finance.
What is Finance?
You must have the feeling that finance deals with money. But if you think about this piece of paper, you certainly don’t know what it truly is.
What is money ?
Thought experiment: I know it seems weird, but take a bunch of paper and throw it or fire it. Now repeat this experiment with a bunch of paper money. The one thing I am sure about, is that you won’t follow the second experiment.
Money is used by almost every human being, it is something that is “good” to possess and is used as a medium of exchange. In some way, you might accord some “value” to this paper ? Let’s try to figure out what it is all about.
Before the use of money, people were battering their goods and services. We all agree that battering is an inconvenient and inefficient trading process. How much bread would you exchange against a doctor’s consultation?
To fit to the problems of bartering, certain commodities were used as a medium of exchange. For example, gold was used because it’s durable, storable and perceived as valuable.
At this stage were created the first banks, a place where people could deposit their commodity. This is an interesting thing: imagine there are a bunch of workers who earned a lot of gold, and in another side, entrepreneurs who have ideas to generate wealth in society. The bank is the intermediary between the laborer and the entrepreneur. The laborer puts its gold in the bank and the bank lends a part of that gold to the entrepreneur. (The part of the gold that the government allows the bank to lend out is called the reserve ratio). As an example, the entrepreneur can build a tunnel under a mountain that allows people to gain a lot of time. This process has generated a growth of wealth.
Banks started emitting banknotes, a paper that represents an amount of a commodity held by the bank. This is much convenient for the worker’s everyday expenses. Now, he could get abanknote stating the amount (or a part) of gold he has deposit in his bank account. This is the first form of commodity money, a money backed by a physical commodity. It was the case of the U.S Dollars that was backed by gold by the U.S Federal Reserve until 1971.
You must pay attention to the fact that commodity money, as the commodity itself, let’s pick for example gold hasn’t got any intrinsic value. Gold by itself is not useful, it doesn’t permit you to live, the eat etc. The only reason why it is valuable is because people want it and believe it is valuable.
Further was introduced the fiat money, it is money that isn’t backed on any physical commodity and that is based on people’s faith, as it is for gold. If people don’t value it, then it ends up worthless. Most of everyday’s money is fiat money.
How is money created?
Nowadays, fiat money system is supervised by an entity called a central bank. A central bank has the right to create and put money into circulation or to take money out of circulation (and destroy it). The process by which it does this, is called an Open Market Operation, it might also put money into circulation by lending it directly to banks. A central bank can also have a regulatory role and might makes decisions such as fixing a bank’s reserve ratio, defined in the previous section. A central bank can be a governmental entity or can be an independent one, but as you can think, it is always closely related to a government.
Money supply, how much money is there in circulation ? Fractional reserve banking and multiplier effect
Let’s say that Bill is a farmer, Joe is an entrepreneur and Bob a tunnel constructor. Let’s say that Bill deposits 3 USD in his checking account in his bank. The bank decides to lend out 2 USD of Bill’s money to Joe, so Joe can construct his tunnel under the mountain.
Now that this process has been executed, Joe pays Bob to construct the tunnel. When Bob has 2 USD in his pocket, he decides to deposit them in the bank. There was only 3 USD in the system at the beginning, there are now 5 USD. Bob owes 2 USD and Joe 3 USD. This is called the multiplier effect. The situation is summarized in the following drawing.
The same effect occurs when the central bank puts fresh money into the system. This loop occurs multiple times (you can check for the maths here). How do we count money? How much of it is there in circulation ? There are several definitions for that:
– M0 / MB: basically how much money there is in absolute value, how much money did the central bank totally emit.
– M1: how much money people believe they have, the amount of money people can directly access to.
About the time value of money
What is an interest ?
Let’s suppose that Bill the farmer find himself with an exceeding of gold and he knows that another person, say Jimmy the woodcutter, needs some gold to start his new business (to buy for example an axe) that will help him to generate wealth (wood). Well, Bill could simply decide to lend his gold to Jimmy (since he doesn’t need it for the moment). The question is: why would he do that and what could be the counterpart?
The fact is that when you lend some money to someone, you temporarily cannot use it, spend it or invest it. This situation is called immobilization of the capital. In the same way, as the person who lives temporarily in your apartment owes you a rent, when you lend some money, you could ask for an equivalent: a rent for a capital. This rent is what we called the interests.
So to sum up the situation, from one side you have people with gold that doesn’t need to be used for their economic activities at the moment, whereas, at the other side, stands a group of people that are in need of some gold to start their activities. The point of interests here is thus to be the cost of the immobilization of extra-gold for the former paid by the latter.
Basically, we deal with two problems of primary importance in finance: allocation of resources and return on capital. Both party find their benefits: on one side, the lender expects to have more gold because of the interests he will receive, and, on the other side, the renter of gold has the opportunity of starting his activities. The question may arise: Is it always as ideal as depicted?
We may wonder how would people choose the right person to whom to lend their gold? Would you rather lend it to a person having planned to go on the moon, or to the woodcutter? The key point here is that we have to introduce the concept of risk. Risk is a major component of finance, because in real life things don’t always go as expected. Nothing guarantees that your investment (loan of extra-gold) will be repaid. The renter may default or die, unexpected events may make his business falling. If we think like that, everybody would simply lend their money to the people having the safest business. The riskiest businesses would never be realized according to this scheme and innovation would go down. The key solution here arises by another question: How do we establish the amount of interests?
Risks and interests rates are fundamentally related. This is why risky projects can be realized. The principle is as follows: the riskier your investment, the higher the interest rate. If you take major risks you’ll expect a high return. On the contrary, if you take low risks, you’ll have a small return on value. It is as simple as that.
So let’s explore what we mean by interest: when you do a loan, you basically lend a certain amount of money, say X. We call this value the principal. Interests are calculated at fixed points in time, it may be calculated in general annually, monthly, weekly, or daily depending on the terms of the loan. Now, and this is the tricky part, there are multiple ways of calculating interests. Roughly speaking, there are two categories of interests: interests based on the principal, and compound interests. Let’s briefly detail these two
Suppose you lend some money at 3% interest on the principal, this simply means that every time the calculation is made, you simply add a fixed 3% of the principal to the due money. Whereas, when you consider compound interests, the distinction between principal (value lent) and interests (the rent) is no longer relevant in the calculation of interests.Each time some interests are added to the amount of money due to the renter, you consider the new amount due to the loaner as a new principal on which you would calculate the following interests.
To conclude, let’s just remember that interests are rents of capital, calculated at fixed time. Moreover, there exists two type of interests: the simple interests (based on the principal) and the compound interests.
Present and future value
Now prepare yourself for a shock. The money value is time dependent. Let’s explore this through an example.
Suppose someone that owes you 1000 dollars says to you: « I know that I owe you 1000 dollars, and I will give you this money back. But, I offer you two possibilities: either I give you 1000 dollars now, or I give you 1030 dollars in a year time. If you don’t need the money right now, you may think the question easy to answer, but it is not. You could think: « Oh, great this guy offers me a 3% interest on my money, I should accept », without thinking of what he’ll do with the money during a whole year. But if you investigate a bit more, you’ll realize that the bank sitting near your home offer a 5% return for a year-time loan risk-free (we will see why it should be risk-free). This implies that by asking your money back right now, you could loan your money to the bank and obtain 1050 dollars in a year. So clearly you should ask your money back right now.
This little example shows the fact that there exists sorts of risk-free investments that generate interests implies that 1 dollar today is less worth than one tomorrow. The money is thus time dependent. The problem that occurs is obviously how to compare investments and cash flows, occurring at different time? The notion of present value helps us doing that. Suppose the risk free-rate is 5%. When you want to compare money at different times, the solution is to evaluate all the money at the present time.
Let’s go back to our example: you have either two possibilities: either choosing 1000 dollars today or 1030 in one year. To evaluate what you should do, you can estimate the value of 1030 dollars in a year. To do this, you search for the present value of 1030 dollars and you obtain the right amount by discounting 1030 dollars by the interest rate you could obtain by investing your money risk-free. So you obtain:
Present value = Future value / Risk-free rate = 1030 / 1.05= 980.95 dollars.
This last amount of money represents the amount of money that will generate 1030 dollars by investing it risk-free at the bank in a year time.
The key concept that you must take home in this example, is that you can’t compare different amounts of money at different times without adjusting the value with respect to the risk-free rate. So in the aim of comparing these amounts, you have estimate their present value. The intuition being that a dollar today will be worth more tomorrow.
One important hypothesis of our discussion is that the we have access to a market which offers risk-free investments (such as bond, treasury bill and so on). If you leave out this hypothesis, our discussion is no more justified, because you just can’t be sure that one dollar today could generate a return tomorrow.
The concept of present value (time-dependency of money) is a fundamental concept in finance. Investors are interested in the rate of return of their investments and it’s natural that everybody should try to maximize this rate. However, as we have already discussed, risk is a fundamental component of investments: if you consider a risk-free investment and its rate of return, it is natural that one would not invest one’s money in a risky bargain if the rate of return is not bigger than the former. It may be seem trivial to you but this is the way of thinking in finance, always deal with risk and rate of return.
A basic balance sheet
What is an asset ?
How would you define an asset in general way? In real life an asset is a useful or valuable quality that a person has. A synonym would be quality or advantage.
In finance, an asset has an economic connotation. It is something you have at your disposal that has an economic value: it can be cash, a house, a product or even a service. Basically it is a resource, that has a value, to you, but more importantly to others because it is worth money.
What is a liability ?
Once again try to think about the meaning of the word liability: it is something that holds you back, an obligation you have. It can be rightly viewed as a handicap. And this definition can be applied accurately to finance. A liability in finance is a debt or an obligation you have contracted during a business process. You free yourself from a liability by giving back, over time, something that has an economic value: it can be services, goods, or also money.
What is a balance sheet ?
A balance sheet, is basically a picture of a company or someone’s financial situation at a precise moment in time. There are three things you should always see in a balance sheet: assets, liabilities and equities. Now we’ve introduced the two first notions, but equity is something new. Think of equity as what you really possess. Assets can be viewed as the appearance, while equity represents the true value. The difference between assets and equity can be shown in this equation:
Equity = Assets – Liabilities (it is a minus sign in there).
Let’s do a basic example: say that you have no debt, or any liabilities. On your bank account your have 5000 CHF. You want to buy a car. It’s price is 10000 CHF. How could you represent your financial situation? Let’s make a balance sheet:
It’s quite clear, that you can’t afford to buy this bike on your own. So you might go to the bank and ask for a loan. The bank might agree to give you a loan of 5000 CHF, which means that your financial situation has changed.
The bank gave you money, so you owe them 5000 dollars (let’s imagine there’s no interests because it is not the purpose of this example). You had 5000 dollars and they gave you 5000 dollars, so your total assets are now worth 10000 dollars, which means that you can buy your car. But what’s important to remember is that, after you bought your car, you still have to pay back the bank. This is shown by the fact that you bought something at 10000 dollars when your equity is only worth 5000 dollars. That’s why as I said before that assets can be viewed as the appearance and the equity as the real value, what you truly own.
Some links useful for you:
What is Finance ?
The allocation of assets and liabilities ? How does our world grow ?
Finance = Science and Process
Finance englobes two notions: On one side, finance is the science of money management. on the other side, finance is the process by which, an entity, acquires the needed funds. In order to obtain funds, you need a second entity to provide you those funds. Finance, thus can be viewed as a bridge between two entities dealing with complementary issues, a bridge which allows them to interact with one another.
The point here is that such entities deal with two problems:
An entity A may need money, in order to execute a task, which can lead to a growth of wealth.
An other entity B may have money and might want to invest it.
It is important to note that, individuals, companies and government are all, on the two sides of the bridge: They provide funds for others, and they seek for fundings. By having a balanced system like this one, we stimulate growth.
Finance can be cut down into four main activities:
– Resource management: Resource management aims at using the resources at your disposal in the most efficient way. These resources can be divided in several forms: goods, investments, or employees in you’re talking of a company. The key word is efficiency
– Investment: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return”.
– Acquisition: In finance, acquisition is the process of taking control of a company by buying the majority, or the totality of its shares. Acquisitions can be friendly or hostile.
– Asset allocation: Asset allocation usually defines the investment strategy, that establishes an equilibrium between risks and rewards depending on the risk tolerance, investments plans, and portfolio’s assets of an entity.
By giving you this definition, you have a very broad understanding of finance. It is important to know that we normally subdivide finance into three categories: personal finance, corporate finance and public finance. Personal finance deals with the financial situation of one person. Corporate finance, as the meaning suggests, is the financial structure of a company. And finally public finance is the portfolio of a government. The differences between each category are linked to the specific needs of each category.
For example, if we consider personal finance, something we all need to think about is retirements expenses and pensions. One way to secure your future, is to invest on a long-term, a part of your revenue in order to enjoy your old days. Corporate finance,on the other hand, may need to have a lot of cash in order to develop their company or fund research projects. Governments must provide infrastructures and services of quality to their population. In order to do this, they need money, which they collect from the taxes each and every one of us pays.
But here the point isn’t to discuss the specificities of each category of finance. Just remember that asset allocation, resource management, acquisitions and investments are the core of finance, and that there are three major categories of finance, with a specific strategy of portfolio scheme in accordance to its needs. Finance is a process and a study. We emphasize the fact that finance is a science based of mathematical analysis, modelling, probabilities and economic theories. As in every other field, some people might ignore the fundamental principles of finance and to things their own way, following their instincts or their wishes, all of which follow the same idea: making money for yourself on other people’s behalf. This doesn’t correspond to finance but rather to speculation.
So this is it for our first article! We hope it was interesting and useful. We strongly encourage you to leave comments: if you would like more precisions on a subject or if you have some suggestions, we’ll be glad to answer. See you in the next article!
Melvin Kianmanesh Rad, Loris Michel, Marc Zaidan.
Introductory picture from: morguefile