The Pillars of Finance

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Lecture 2, The Pillars of Finance

Lecture two was about how capital is allocated in three different groups (households, companies and government), more information about General Equilibrium Theory and The Efficient Market Hypothesis. Lecture two also introduces the three pillars of finance.

Capital is allocated to company which purchase example new machinery or new place, to households who want’s loan to buy a new house and to government who wish to undertake higher current and capital expenditures.

All these groups face the same question about the cost of loan, what kind of interest is there? Interest rates define how “expensive” loan is going to be. Short term rate is determined by central bank (base rate, repo rate, Fed Funds rate) and all others rates are determined by market force.

I learned that people can be risk bearing, risk averse or risk lover. That sounds pretty weird for me at first that all people can be divided like that. In finance world if you try to get financial resources, it is also about distribution of economic risks. Some people are willing to take bigger risk to get money and some people wants to avoid risks and do “easy money” (which doesn’t even exist). Examples of risks: credit risk, equity risk, currency risk, interest rate risk and commodity price risk.

Science has always tried to explain whole business functions and there are three important pillars to science. Pillar one is about optimization over time and something about time value of money. I realized that pillar one is in important in firms that are considering if they should spend money to something that brings money in the future, and if the target is good spending. Also individuals have the same kind of problems. They need to make a decision on investment (education, loan). Government faces the same problems of spending.

Pillar two is about risk management. I learned that risk is possibility of surprising outcome. Risk is measured from the...
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