What is Finance and Financial Instruments

What is Finance?

Finance is the allocation of assets, liabilities, and funds over time, process, mediums to reap the most out of the activity. In other words, managing or multiplying funds to the best in interest while tackling the risks and uncertainties.

Key Takeaways

  • Finance is a term broadly describing the study and system of money, investments, and other financial instruments.
  • Finance can be divided broadly into three distinct categories: public finance, corporate finance, and personal finance.
  • More recent subcategories of finance include social finance and behavioral finance.
  • The history of finance and financial activities dates back to the dawn of civilization. Banks and interest-bearing loans existed as early as 3000 BC. Coins were being circulated as early as 1000 BC.
  • While it has roots in scientific fields, such as statistics, economics, and mathematics, finance also includes non-scientific elements that liken it to an art.

Understanding Finance

“Finance” is typically broken down into three broad categories: Public finance includes tax systems, government expenditures, budget procedures, stabilization policy and instruments, debt issues, and other government concerns. Corporate finance involves managing assets, liabilities, revenues, and debts for a business. Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings, and retirement planning.

History of Finance

Finance, as a study of theory and practice distinct from the field of economics, arose in the 1940s and 1950s with the works of Harry Markowitz, William F. Sharpe, Fischer Black, and Myron Scholes, to name just a few.234 Particular realms of finance—such as banking, lending, and investing, of course, money itself—have been around since the dawn of civilization in some form or another.

The financial transactions of the early Sumerians were formalized in the Babylonian Code of Hammurabi (circa 1800 BC). This set of rules regulated ownership or rental of land, employment of agricultural labor, and credit.5 Yes, there were loans back then, and yes, interest was charged on them—rates varied depending on whether you were borrowing grain or silver.

By 1200 BC, cowrie shells were used as a form of money in China. Coined money was introduced in the first millennium BC. King Croesus of Lydia (now Turkey) was one of the first to strike and circulate gold coins around 564 BC—hence the expression, “rich as Croesus.”6

In ancient Rome, coins were stored in the basement of temples as priests or temple workers were considered the most honest, devout, and safest to safeguard assets. Temples also loaned money, acting as financial centers of major cities.7

What are Instruments in Finance?

For availing financial services an individual or company needs financial instruments. A Financial Instrument is a contract between two parties and involves monetary activities. Financial instruments can be used for investment purpose or lending and borrowing purpose. Financial instruments are either classified as Cash Instruments or Derivative Instruments:

What are Cash Instruments?

The value of Cash Instruments is determined by market forces. Cash instruments involve instruments that are easily transferable by the parties. It could be in the form of securities, loans or deposits. The different types of cash instruments available in the market are certificates of deposits, repurchase agreements like the Repos, bills of exchange, interbank loans, commercial papers, e securities and many more.

What are Derivative Instruments?

The value of Derivative Instruments is derived from the valuation of another entity which can be an asset, or an index, or any other factor that can influence the value of the derivatives. The different types of derivative instruments available in the market are futures, forwards, swaps, and options.
Financial instruments are also classified based on their asset class. Financial instruments can be debt-based or equity-based. A debt-based instrument is in the form of loans that the issuing party avails from the investors. Whereas, equity-based instruments reflect ownership based on the share of equity an investor holds.
Debt-based financial instruments include bonds, bond futures and options, Interest rate swaps, Treasury bills, Interest rate futures and forward rate agreements. Another type of asset class is the Forex Instruments which includes forex futures, forex options, currency swaps and more.

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