CHAPTER PREVIEW - 1-1 Chapter 1 The Financial Environment CHAPTER...

Chapter One: The Financial Environment

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Chapter 1 The Financial Environment

CHAPTER PREVIEW

This first chapter provides an overview of the three areas of finance—institutions and markets, investments, and financial management. We begin by providing clear answers to the following two questions: What is finance? Why study finance? To underscore the importance of studying finance, we briefly discuss how the financial environment changed during the early-part of the twenty-first century. Six principles of finance are identified and discussed: time value of money, risk versus return, diversification of risk, financial markets are efficient, management versus owner objectives, and reputation matters. The basic requirements of an effective financial system need to be understood in order to tie finance into the economy in general. We also discuss the financial functions in the U.S. system: creating and transferring money, accumulating and lending/investing savings, and marketing and transferring financial assets. We then identify financial markets characteristics and describe major types of financial markets. We next follow with a brief discussion of some of the careers available in finance and use this introduction about finance careers to provide the basis for more detailed discussions in later chapters. The chapter concludes with a description of the plan of study for the book.

LEARNING OBJECTIVES

LO 1.1 Define finance and describe the three areas of finance.LO 1.2 Explain why finance should be studied.LO 1.3 Describe and discuss the six principles of finance.LO 1.4 Identify the four components of the financial system and describe their roles.LO 1.5 Describe financial markets characteristics and the four types of financial markets.LO 1.6 Identify several major career opportunities in finance.LO 1.7 Describe this textbook’s plan of study.

CHAPTER OUTLINE

I. (1.1) WHAT IS FINANCE?

• Two Themes

II. (1.2) WHY STUDY FINANCE?

III. (1.3) SIX PRINCIPLES OF FINANCE

• Time Value of Money
• Risk Versus Return
• Diversification of Risk
• Financial Markets are Efficient
• Management Versus Owner Objectives

(Introduction to Finance Markets, Investments, and Financial Management, 17e Ronald Melicher, Edgar Norton) (Solution Manual all Chapters) 1 / 4

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• Reputation Matters

IV. (1.4) OVERVIEW OF THE FINANCIAL SYSTEM

• Characteristics and Requirements
• Financial System Components and Financial Functions
• Creating Money
• Transferring Money
• Accumulating Savings
• Lending and Investing Savings
• Marketing Financial Assets
• Transferring Financial Assets

V. (1.5) FINANCIAL MARKETS: CHARACTERISTICS AND TYPES

• Money and Capital Markets
• Primary and Secondary Markets
• Major Types of Financial Markets

VI. (1.6) CAREERS IN FINANCE

VII. (1.7) THE PLAN OF STUDY

VIII. SUMMARY

LECTURE NOTES

I. (1.1) WHAT IS FINANCE?

Capitalism is an economic system with private ownership of assets, production of goods and services for profit, a price mechanism for allocating resources, and financial markets.The United States is a mixed market capitalistic system. We describe finance in the context of the U.S. economic system.

Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial resources. The financial environment encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently.

The three areas of finance within the financial environment and financial system are: institutions and markets, investments, and financial management. Financial institutions are intermediaries that help the financial system operate efficiently and help transfer funds from savers to investors. Financial markets are physical locations or electronic forums that facilitate the flow of funds. Investments involve the marketing of securities, securities analysis, and the management of investment risk. Financial management involves financial planning, asset management, and fund raising decisions to enhance the value of firms. 2 / 4

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Within the context of the three areas of finance we cover the themes of small business management and personal financial planning. Entrepreneurial finance studies how growth-driven, performance-focused, early-stage firms raise financial capital and manage their operations and assets. Personal finance studies how individuals prepare for financial emergencies, protect against premature death and the loss of property, and accumulate wealth over time.

(Use Figure 1.1 and Review Questions 1 through 4 here.)

II. (1.2) WHY STUDY FINANCE?

The first eighteen years of the twenty-first century has been characterized by a volatile economic environment in the U.S. A price bubble for technology stocks (including dot.com start-ups) burst in 2000. A subsequent economic downturn was made worse by the September 11, 2001 terrorist attack. Although there followed a period of economic recovery, a housing price bubble burst in 2006. Debt securities tied to housing prices subsequently fell causing many financial institutions to be pushed to the brink of failure which led to the 2007-08 financial crisis. The economy entered the 2008-09 Great Recession. Although economic recovery was slow, unemployment rates, which exceeded 10 percent in 2009, dropped to the 5 percent level by the end of 2015 and below 4 percent by the end of 2018.

We encourage instructors to spend time at the beginning of the course explaining to, and discussing with, their students about the importance of studying finance. We suggest several reasons why students should study finance.

• First, as a citizen (of the U.S.A. or another country), you should want to make

informed economic decisions. Whatever your financial and economic goals may be, you need to be an informed participant if you wish to “make a difference.” The operation of the financial system and the performance of the economy are influenced by policy makers. The citizens elect important policy makers such as the President and Congress who can pass or change laws, and through their decisions impact on the level of economic activity. Thus, it is important that citizens be informed when making political/economic choices.

• Second, having some knowledge about finance, particularly the financial markets or

investments component, should be important to you. An understanding of various aspects of personal finance should help you better manage your existing financial resources, as well as provide the basis for making sound decisions for accumulating wealth over time.

• Third, to be successful in the business world, it is important to have a basic

understanding of business finance in addition to an understanding of macro finance and investments (financial markets). Even if your “business interest” is in a non- 3 / 4

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finance career, you likely will need to interact with finance professionals both within and outside your firm. To do so will require a basic knowledge of the concepts, tools, and applications of business finance.

(Use Review Questions 5 and 6 here.)

III. (1.3) SIX PRINCIPLES OF FINANCE

Finance is founded on six principles. They are:

• Money has a time value.
• Higher returns are expected for taking on more risk.
• Diversification of investments can reduce risk.
• Financial markets are efficient in pricing securities.
• Manager and stockholder objectives may differ.
• Reputation matters.

An individual’s reputation reflects his/her ethical behavior which is how an individual treats other legally, fairly, and honestly.

(Use Review Questions 7 and 8 here.)

IV. (1.4) OVERVIEW OF THE FINANCIAL SYSTEM

A democracy is a system of government where limited authority and power are granted by law to its people to vote on government policies and issues. The United States of America is a representative democracy where U.S. citizens elect representatives from amongst their peers to participate in formulating government policies and plans and addressing government issues. This system of representative democracy provides the framework for viewing and describing the U.S. financial system in this textbook.

An effective financial system is a complex mix of government and policy makers, a monetary system, financial institutions, and financial markets that interact to expedite the flow of financial capital from savings into investment. Basic requirements for an effective financial system include: a monetary system, a savings-investment process, and financial markets. The monetary system must provide an efficient medium for exchanging goods and services. This is accomplished by an efficient system for creating and transferring money. The financial system must also be able to allow capital formation by channeling savings into investment. In addition, markets must exist in which to buy and sell measures of (or claims to) wealth, such as financial assets or real estate.

In a simple economy, such as a self-sufficient farm, a farmer can create capital by building a new barn. Capital formation takes place indirectly in a highly developed economy. For example, individuals may save a portion of their current income which is, in turn, loaned to others who want to purchase equipment.

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