Financial Economics: Term Definition

Introduction

According to Bodie et al (2008), “Finance is a scientific discipline is a study of how to allocate scarce resources over time under conditions of uncertainty”. Financial details have to be specified with good decision-making. Scarce resources attribute to the finances related to the costs that an economy possesses. It is largely attributed that finance is the process of deploying economic resources in an environment that offers unsure phenomena (Drazen, 2000). It is important to note that assessment of the monetary activities is essential because it is involved in the terms of trade. Time, important details, and choices should be highlighted in order to fully understand proper financial management. Time depicts the duration and trends where it is traded. Allocation of scarce resources is also open for a lot of risks where it basically suggests that the amount of money is not certain in the long run or in the future (Allen and Gale, 2004). Choices should also be acquainted with the decision-making process because both parties need to come out with a decision that will take effect on the monetary activities. Knowledge of the financial systems also needs to be noted as it plays a significant role in lessening the risks that are linked with the future monetary value.

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Financial decisions of the household and firms are considered to be a long-term finance decision and which is associated with the fixed assets and capital structure and the decisions mainly depend on the criteria. It looks for the maximization of the value of the firm through the investments on the projects which will give a net present value if calculations will be made using an appropriate discount rate. Decisions also comprise the capital investment allocation especially those that are central to the limited resources between the competing opportunities through the process which is recognized as capital budgeting. Allocation of capital resources decisions requires the estimation of the value for a particular project.

Overview of the Financial System

The financial system is regarded as an exemplar that depicts the transaction between the borrowers and the savers. The system of finance goes with the cycle of borrowing and saving in a bank or through other financial instruments that are used.

The functional perspective attributes the important considerations in order to come out with an effective decision. These functional perspectives comprised of analyzing the problem, setting the goals and objectives, identification of alternatives and developing a contingency plan, and an assessment of the positive and negative characteristics wherein all areas are vital.

As such, innovative designs the use of computer and telecommunications technology, and the modern theories of finance initiated the drastic and quick response to the model of global financial markets and institutions. Functional perspective is described as the conceptual framework for assessing various ideas in the changes of the institution through financial intermediation. Using concrete examples in order to define the set of institutional changes which is expected to occur in the future may reflect some managerial issues concerning the process of production for the intermediaries as well as the regulatory process.

Financial innovation is defined as the advances in the aspect of technology that serves as the source of information, trading, and means of payment and to the emergence of new financial instruments and services. In addition to, innovation in the financial sense reveals modern forms of organization and financial markets. To be able to keep track of the emerging industries in the world, financial innovation should know how to estimate and lessen the expenses and risks which may provide an improved service that will reach the specific needs of the members of the financial system.

Market rates on the other hand are the current interest rate that is available in the market. Market rates occur when there is a market for an investment which includes the money market, bond market, stock, and currency market and also the retails financial institutions such as banks. How the said markets relate to the market rates basically caters to a complex detail. Consequently, these markets determine the interest rates through investments (Sullivan and Sheffrin, 2003).

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Financial intermediaries are commonly the institutions that handle the transaction of funds between the savers and the borrowers. The savers, therefore, are the ones who give the money to an institution, and thus, the institutions are the ones to give the money to the borrowers. As such, these institutions may comprise; banks, building societies, pension funds, collective investment schemes, brokers, insurance companies, and credit unions (Siklos, 2001).

These institutions are mainly for facilitating the payments for goods and services through the checks that the payers provide. Financial intermediaries are responsible for the constraints in liquidity on households and firms which occurs when the liquidity available for a specific investment is at variance with an easy flow of available income like the mortgages that tolerates the households in buying cars now rather than in the future.

Analyze Financial Planning

Constructing a financial model is largely important for the firm to determine its success. Financial planning details the whole structure of operating the firm and evaluates the efficiency of the financial tools used in the system.

Capital management serves as the efficient manipulation of the investments in a firm which significantly depicts the appropriate decisions for working capital. Short-term financing is also referred to as capital management for a specific project. It comprises management of the links between the short-term assets of the firm together with its short-term liabilities. Corporate finance primarily caters to the maximization of the value of a firm and in the long run, the capital investment decisions are enhanced by choosing the positive investments that have implications in terms of the cost of capital and cash flows. Apparently, the role of capital management is to make sure that the firm can operate and has enough cash flow to serve for a long-term debt which will meet the maturing short-term debt and the upcoming operational costs (Sullivan and Sheffrin, 2003). The financial system gives the economies of scale and the economies of scope which opens the investment for an individual to achieve a portfolio for their assets and this is more complicated if financial intermediaries do not stand in between as they set the grounds for money transactions (Siklos, 2001).

For some instances, dilemmas in the financial area are pointed to the financial instruments but in fact, it just depends on the way it is being manipulated and managed by the financial specialists. A highlight is given to the issue of providing a zero-price option to the people. Thus, people can buy something with zero money and get profits if the price of the purchased good goes up. Loans are considered non-recourse though and are safe if the price turns down. Having choices indeed seems to be a problem or the way the financial aspect is manipulated and not the financial instruments. Hence, the modern financial instrument is the one seen that has saved US banks who failed to absorb their own liabilities and losses (Siklos, 2001).

Most commonly, financial planning is comprised of a process wherein it considers the condition of the client in any vital area to provide contingency plans and identify the key factors for success.

Analysis of Investment Projects

The capital budget largely relates to the fixed assets in the future. The capital budget is composed of different aspects that a firm uses in its operation. Budgeting of capital is important to be able to monitor the business and to make sure that there are enough funds available to meet the expenses on hand. Basically, capital budgeting requires a detailed plan that reflects all expected sources and usage of the capital.

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Sensitivity analysis explores the uncertainty in the output of a mathematical model. It is important for investment projects in order to investigate the generality of a study if it has mathematical exemplars (Saltelli et al., 2000). According to Kennedy (2007), sensitivity analysis is important in assuming criticisms which is related to one of the ten commandments of applied econometrics.

The influence of inflation in capital budgeting has been linked with economic instability most especially in the related prices of goods. Inflation over the years has not been a major macro-economic problem but it is regarded as a specter that is presented by the increases in the interest rates (Ullman, 2006). The instability of the macroeconomy pointed that it is necessary to evaluate the expectations through the future rate of inflation which should be taken into account in making such decisions for a project.

Some economic theories back up the idea that the interest rates should be moved in a similar direction to the assumed rate of inflation. The quantity theory of money somehow debates with the exact shift though and under the loanable fund’s theory, the money demand should increase for the reason of having an increased transaction in demand. On the other hand, the supply of these funds therefore would lessen as the excess spending lessens as well. Hence, the actions require the cost of money to get higher (Sullivan and Sheffrin, 2003).

Financial Structure of the Firm

Capital decisions are aiming for the goal of the corporate investment that should be financed accordingly. The riskiness of a firm can somehow impact the valuation aspect and management thus needs to be sensitively treated. The financing sources are largely composed of the links between debt and equity. Financing a project by debt may result in a liability that should be serviced and therefore, implications for a cash flow are separated from the success of the project. The firm should try matching the financing mixes to the asset which is being financed as much as possible in the sense of duration of time and cash flows (Kennedy, 2007). As used by different sectors, finance should be considered through its institutional setting together with the use of the appropriate financial instruments and methodologies. The financial structure of the firm though needs proper financial planning and management of the investments to assure that the future of the firm would be successful.

If the financial structure is not important in a perfect market, thus these details that occur in the real scenario can be the reason why such irrelevance exists. A perspective given to the financing decisions is the Pecking Order Theory which says that firms are avoiding the external financing while having an internal one and the new equity financing while they can be involved in a debt financing that offers lower interest rates (Saltelli et al., 2000).

Financial leverage is described as the degree to which the fixed-income securities are being used as a capital structure of a firm. A firm is claimed to be in a high degree of financial leverage if the capital structure of a firm is prevailing a high percentage and is in the form of debt and preferred stock.

The financial structure, therefore, is vital for a firm in order to succeed. Ensuring that the capital investments and other assets of the company are doing good, it should also be noted that these areas are the main factors that lead the company to success.

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Executive summary

Financial economics is also into creating models in obtaining the implications from the theories. Regularly, the principles account for the financial decisions that act reasonably. There have been researchers that tested the empirical assumptions in experimental economics and experimental finance. Finance takes into consideration the uncertainty of time and it requires a good plan because the assumptions for the future are varied. The future seems to be one of the factors in understanding finance as it does not give a definite idea on how long the resources would last and how efficient the current allocation of resources would be. The following perspectives discussed above points out the details of financial grounds that needed to consider for decision making. Managers should fully understand the financial matters of a firm beforehand in making a decision as it depicts a lot of risks that the firm may encounter in the future.

The importance of finance largely calls for the specific details that deal with the formation of the principles in decision making. Defining the grounds for the allocation of resources in an economy or in an organization would likely result to the specification of what the financial and monetary activities is all about. Assumptions should be considered in order to come up with a good decision for an organization where finance plays a significant role. The leaders of an organization should know how to balance the activities involving money because it is a sensitive factor for the success of the organization as well as the economy. Finance covers all aspects of the economy down to organizations thus, it needs proper planning.

References

Allen, F. & Gale, D. (2004). “Financial Intermediaries and Markets Financial Intermediaries and Markets”, Econometrica, Vol. 72, No. 4 (2004), pp. 1023-1061.

Bodie Z., Merton, R. & Cleeton, D. (2008). “Financial Economics”, 2nd Edition, Prentice Hall.

Drazen, A. (2000). Political Economy in Macroeconomics. Princeton, nj: Princeton University Press.

Kennedy, P. (2007). A guide to econometrics, Fifth edition. Blackwell Publishing.

Saltelli, A., K. Chan, and M. Scott (Eds.) (2000). Sensitivity Analysis. Wiley Series in Probability and Statistics. New York: John Wiley and Sons.

Siklos, P. (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. p. 35.

Sullivan, A.; Sheffrin, S.M. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 551.

Ullman, D. G., Making Robust Decisions Trafford, 2006.

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