An Introduction to Financial Markets

Chapter One Financial Markets: Functions, Institutions, and Traded Assets

Providing a simple, yet exhaustive definition of finance is no quite easy task, but a possible attempt, at least from a conceptual viewpoint, is the following:¹

Finance is the study of how people and organizations allocate scarce resources over time, subject to uncertainty.

This definition might sound somewhat generic, but it does involve the two essential ingredients that we shall deal with in practically every single page of this book: Time and uncertainty. Appreciating their role is essential in understanding why finance was born in the past and is so pervasive now. The time value of money is reflected in the interest rates that define how much money we have to pay over the time span of our mortgage, or the increase in wealth that we obtain by locking up our capital in a certificate of deposit issued by a bank. It is common wisdom that the value of $1 now is larger than the value of $1 in one year. This is not only a consequence of the potential loss of value due to inflation.² A dollar now, rather than in the future, paves the way to earlier investment opportunities, and it may also serve as a precautionary cushion against unforeseen needs. Uncertainty is related, e.g., to the impossibility of forecasting the return that we obtain from investing in stock shares, but also to the risk of adverse movements in currency exchange rates for an import/export firm, or longevity risk for a worker approaching ...