Basic Financial Instruments

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Origin of the word “finance”
Two versions:
medieval Latin language (XIII-XIV centuries) contained words finatio, financia meaning “obligatory payment”; in English language the word is alleged to be derived from the word fine (XI century) which was the synonym of tax.

Finance: evolution of meaning
XVIII century – mid-XX century – “finance” meant funds of the state; since mid-XX century – “finance” also covers the area of financial decisions made by corporations and individuals.

□ Finance can be defined as the art and science of managing money [Gitman, 1989]. □ Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses and governments. Main areas of finance

□ Public
□ Corporate or business
□ Personal

Basic types of business organization
□ Sole proprietorship
□ Partnership
1. general partnership
2. limited partnership
□ Corporation

sole proprietorship
1. Easy to create
2. Owner receives all profits
3. Low organizational costs
4. Flexible
1. Owner has unlimited liability for proprietorship’s debts 2. Limited life cycle
3. Low fund-raising power
1. Easy and inexpensive to form

1. Owners (general partners) have unlimited liability for partnership’s debts 2. Limited life cycle due to difficulties to transfer ownership Characteristics of corporation
□ Separate legal entity
□ The shareholders have a limited liability for the business debts □ It’s difficult to create:
■ Articles of incorporation
■ Set of bylaws
□ Separation of ownership and management
■ ownership can be relatively easily transferred
□ Provides an ample opportunity to raise capital
□ Main disadvantage: possible mismatch between objectives of managers and shareholders. Corporate financial decisions
□ Financing decision – where is money going to come from □ Investment decision – how much to invest and in what assets Financial management decisions
1. Capital budgeting decisions: what long-term investments should we take on? 2. Capital structure decisions: What are the sources of long-term financing? (equity, loans) 3. Working capital management decisions: how should we manage everyday financial activities? (collecting receivables, paying suppliers etc.) Finance function – managing the cash flow

The goal of financial management
Maximizing shareholder’s wealth
Maximizing stock prices
Objectives for financial manager
□ Maximizing earnings and earnings growth
□ Maximizing return on assets and return on equity

Financial markets
□ The main goal of financial markets:
Take savings from those who do not wish to consume (savings surplus units) and to channel them to those who wish to invest more than they have presently (saving deficit units)

Bank reward = Kl - Kd

Financial markets
1. Primary markets Secondary markets
2. Money market Capital market
3. Organized exchanges Over-the-counter

□ Primary market – primary issues of securities are sold, allows governments, banks, corporations to raise money by directly selling financial instruments to the public. □ Secondary market – allows investors to trade financial instruments between themselves. Secondary transactions take place. Money markets – short-term assets (maturity less than 1 year) are traded: • Certificates of deposits (CDs)

• Commercial papers (CPs)
• Treasury bills
Capital markets – long-term assets (maturity longer than 1 year) are traded: • Stocks
• Corporate bonds
• Long-term government bonds
• Organized exchange – most of stocks, bonds and derivatives are traded. Has a trading floor where floor traders execute transactions...
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