See D. Allen, Finance (1983); D. Swain, Managing Public Money (1987); L. Harris et al., ed., New Perspectives on the Financial System (1988); N. Gianaris, Contemporary Public Finance (1989).
Specialized financial institution that supplies credit for the purchase of consumer goods and services. Finance companies purchase unpaid customer accounts at a discount from merchants and collect payments due from customers. They also grant small loans directly to consumers at a relatively high rate of interest.
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Process of raising funds or capital for any kind of expenditure. Consumers, business firms, and governments often do not have the funds they need to make purchases or conduct their operations, while savers and investors have funds that could earn interest or dividends if put to productive use. Finance is the process of channeling funds from savers to users in the form of credit, loans, or invested capital through agencies including commercial banks, savings and loan associations, and such nonbank organizations as credit unions and investment companies. Finance can be divided into three broad areas: business finance, personal finance, and public finance. All three involve generating budgets and managing funds for the optimum results. Seealso corporate finance.
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Acquisition and allocation of a corporation's funds or resources, with the goal of maximizing shareholder wealth (i.e., stock value). Funds are acquired from both internal and external sources at the lowest possible cost and may be obtained through equity (e.g., sale of stock) or debt (e.g., bonds, bank loans). Resource allocation is the investment of funds; these investments fall into the categories of current assets (such as cash and inventory) and fixed assets (such as real estate and machinery). Corporate finance must balance the needs of employees, customers, and suppliers against the interests of the shareholders. Seealso business finance.
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Raising and managing of funds by business organizations. Such activities are usually the concern of senior managers, who must use financial forecasting to develop a long-term plan for the firm. Shorter-term budgets are then devised to meet the plan's goals. When a company plans to expand, it may rely on cash reserves, expected increases in sales, or bank loans and trade credits extended by suppliers. Managers may also decide to raise long-term capital in the form of either debt (bonds) or equity (stock). The value of the company's stock is a constant concern, and managers must decide whether to reinvest profits or to pay dividends. Other duties of financial managers include managing accounts receivable and fixing the optimum level of inventories. When deciding how to deploy corporate assets to increase growth, financial managers must also consider the benefits of mergers and acquisitions, analyzing economies of scale and the ability of businesses to complement each other. Seealso corporate finance; inventory.
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U.S. government agency established (1932) to provide loans to railroads, banks, and businesses. The RFC was an attempt by Pres. Herbert Hoover to counter the early effects of the Great Depression by rescuing institutions from default. It was widely used by Pres. Franklin Roosevelt in the New Deal and to finance defense plants in World War II. After the war, the RFC's powers and functions were gradually transferred to other agencies.
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The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs. Credit derivatives have become an increasingly large part of the derivative market.
Also, stock index futures and options are known as derivative products because they derive their existence from actual market indices, but have no intrinsic characteristics of their own. In addition to that, one of the reasons some believe they lead to greater market volatility is that huge amounts of securities can be controlled by relatively small amounts of margin or option premiums. One reason derivatives are popular is because they can be transacted off-balance-sheet.
The strictest absolute hedging practice is employed by a merchant banker who buys in the cash/physical market and sells in the futures market. When he later sells his commodity in the cash market and covers his futures contract(s), he has held the asset without market exposure. This can also be accomplished in conjunction with puts and calls by managing the hedge ratio (delta) to neutral.
In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgement on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution.
|Bold text>Exchange-traded futures||Bold text >Exchange-traded options||Bold text>OTC swap||Bold text>OTC forward||Bold text>OTC option|
|Bold text" >Equity Index|| DJIA Index future |
NASDAQ Index future
| Option on DJIA Index future |
Option on NASDAQ Index future
|Money market|| Eurodollar future |
| Option on Eurodollar future |
Option on Euribor future
|Interest rate swap||Forward rate agreement|| Interest rate cap and floor |
|Bonds||Bond future||Option on Bond future||n/a||Repurchase agreement||Bond option|
|Single Stocks||Single-stock future||Single-share option||Equity swap||Repurchase agreement||Stock option|
|Credit||n/a||n/a||Credit default swap||n/a||Credit default option|
Other examples of underlying exchangeables are:
Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.
For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate.
Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.
(See Berkshire Hathaway Annual Report for 2002)
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