Chapter 1, Lesson 1: The Art of Making Things Happen

What is finance?

Simply put, finance can be defined as the management of assets and liabilities. Assets are anything with economic value, meaning they have a monetary value and can be exchanged for cash. Liabilities, are the opposite. They are the obligations an entity owes another in turn for something in the present. One of the key aspects of liabilities is interest. Interest is the amount an entity pays another in turn for something and is often calculated as a percentage of the monetary value of the item or service exchanged. Another definition of finance, according to Robert J. Shiller, professor of economics at Yale University, is that it is the art of “making things happen”. This alternate view is quite accurate in our capitalist society, where almost every action is governed by the allocation of money. For instance, if a political party in control of a municipal government wanted to build a bridge to please the municipality’s population and stay in power, but does not have the money on hand to do so, it could issue municipal bonds, a form of debt, to raise capital (money), in order to finance the construction of the bridge. This is an example of public finance, one of the three areas of finance. Second, corporate finance is the management of corporate assets and liabilities, often with the main focus of increasing the value of the firm (the company). In order to do so, the company may take on debt to finance its operations, which will then generate revenue which it will use to pay off the debt and fund new operations, in a continuous cycle. Companies can also finance their operations without taking on debt by issuing stock, which represents ownership of said firm. Buyers pay the company for this ownership, for a variety of reasons, but regardless it generates capital for the company to finance its activities.

How does finance affect you?

Lastly, the third area of finance is personal finance. Let’s say you want to buy a car, but you don’t have the cash to buy it outright. You could take on debt, a liability, to finance your purchase and pay for it in increments over time. Financing does not always entail taking on debt. For example, if you wanted a new blouse and did not have the money for it, you might exchange your time and work abilities for money with a local business. You would then use the profits (the money left over after all deductions, such as tax and social insurance payments), from this revenue to buy the blouse. All of these actions require management in order to allocate assets and liabilities to make things happen. Without even knowing it, people are financiers every day. They manage their money to make things happen, such as buying a home, a car, food and clothes. Aside from personal finance, the financial actions of your government and the companies that provide you with goods also affect your day-to-day life. All area of finance interact and this makes up the economy. In many ways, how you interact financially with other entities is very much in your control, and this blog will have a specific focus on how you can manage your assets and liabilities in order to profit from the financial actions of other people, companies, and governments.

A very, very brief and simplified timeline of finance

  • 14th century: Venetian moneylenders exchanged loans with each other and bought government debt, the first bonds. They sold government debt to individuals, who became the first individual investors.
  • 1531: Belgian brokers and moneylenders in Antwerp traded government, corporate, and individual notes and bonds (debt) on the first exchange.
  • 1602: The Dutch East India Company (VOC) is formed and revolutionized the ship voyage industry by issuing merchants shares in the enterprise and dividends on the proceeds of the company’s ships’ voyages, instead of on a ship-by-ship basis as done previously. It was thus the first company to have an initial public offering.
  • 1637: Tulips imported by the VOC became a status symbol in Holland and prices skyrocketed, especially for the most rare bulbs. Contracts to purchase bulbs later at a specified price were created and became some of the first futures contracts. Then, in Haarlem, bubonic plague broke out and for the first time, buyers stopped showing up to tulip bulb auctions in the city. This caused the deliveries described in the contracts to never occur and the contracts were not fulfilled. This caused tulip prices to collapse and trade ground to a halt. The Dutch tulip mania became one of the first market bubbles to burst.
  • 1773: London Stock Exchange is established, but due to stock crash of the South Seas Company, the British government banned issuing shares until 1825. This severely limited the action of the exchange.
  • 1792: The New York Stock Exchange is established, though not the first in the United States, a title held by the Philadelphia  Stock Exchange, the NYSE soon became the most important in the country.
  • 1896: The Dow Jones Industrial Average is calculated for the first time, becoming the first stock market index. It tracks the performance of the 30 largest publicly traded companies in the United States.
  • 1900: The United States accounts for 22% of the global stock market, the second largest player.
  • 1929: During the “roaring twenties”, post World War I optimism led to excessive speculation and a subsequent rapid rise in stock prices. Industry could not keep pace with the increasing valuations of companies and as industrial production declined and debt increased, financial expert Robert Babson predicted a crash. This in turn caused the New York Stock Exchange to crash on October 24, a day known as Black Thursday. Thousands of investors lost their entire investments, and the following Tuesday the DJIA dropped 12%, the second largest decline in its history.
  • 1970s: Deregulation and advances in computer technologies led to the increased use of derivatives.
  • October 19, 1987: Stock markets worldwide crashed, beginning in Hong Kong and moving west. With the collapse of OPEC the previous year, the DJIA peaking in August of 1987 and falling after the closure of the London Stock Exchange, and escalating tensions between the U.S. and Iran in the Persian gulf, markets began to decline as the morning travelled west around the world, beginning in Asia.
  • 1992: The Chicago Mercantile Exchange is the first to implement electronic trading.
  • 2000: The dot-com bubble reaches its peak, then bursts. With the advances in information technology, internet startups received massive valuation from speculative buyers. Some firms had billion dollar valuations with no profits, giving them astronomical P/E ratios, if any. When the bubble burst, stocks like Amazon and eBay went from around 100 dollars per share to around 7 dollars per share. Many of the companies of the bubble consolidated and are now trading at hundreds of dollars per share.
  • 2008: The Great Recession cripples global economies in the worst economic contraction since the second world war. Beginning in 2007, major lending agencies in the U.S. packaged risky mortgages into financial products called “collateralized debt obligations” (CDOs) which were given the highest ratings by rating agencies. When homeowners defaulted on their mortgages, the system imploded. With a grotesque lack of regulation of financial institutions, large amounts of household debt, Chinese growth, and massive trade deficits, a global recession ensued.

Now that we’ve scratched the surface, I hope you have a better general idea of what constitutes finance and its applications to your life and the world. Now that that’s out of the way, check back for the next chapter, Financial Markets, where you will get a taste of what vehicles, instruments, and organizations move the global financial system.

Next up: Chapter 2, Lesson 1: Financial Vehicles (Yes, hedge fund managers drive Porsches, but that’s not what we’re talking about)


Sources:

Image disclaimer: If the image in this article belongs to you and you would like credit, please identify yourself and I will include credit below. If you would like it removed, please leave a comment and I will take it down.

Advertisements

Leave a reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s