Mention the term ‘finance’ and many people will likely relate it to anything to do with money. Taking out a mortgage to purchase a home or vehicle, for example, might come to mind in this regard, and that’s largely correct. However, finance is a much broader discipline that represents money, currency and assets and the systems put in place to manage and facilitate the transfer of these elements.
Naturally, there are ways to ensure these financial elements work. As Massimo Acquaviva – 2R Capital Investment Management Limited co-founder and co-CEO – knows, these ways are encapsulated in various financial theories that outline the principles and relationships that govern how finance works. Some of these include:
- Risk and Return: Financial investments carry an element of risk, which has a relationship with the form and magnitude of return expected. Generally, higher levels of risk can provide potentially higher returns, so investors are always looking for opportunities that align with their risk-return appetite.
- Time Value of Money: The time value of money principle states that money in the present day is more valuable than the same amount in the future. Various factors account for this, but in essence, it forms the basis for various valuation models and discounted cash flow analysis.
- Capital Structure Theory: The mix of financing options that companies use to fund operations is an interesting topic, as it addresses the debt-equity interaction. The mix of these elements – the capital structure – is a big factor in a company’s cost of capital and determination of its value.
- Portfolio Theory: This theory focuses on the value of diversifying investments as a way of reducing risk. It suggests that investors should consider building their portfolios through different assets to balance the risk-reward trade-off more optimally.
- Behavioural Finance: This aspect of finance explores how psychological factors (social pressure, bias, emotions) play a role in financial decision-making.
- Agency Theory: This theory digs deeper into the relationships between the different stakeholders in a business and the potential conflicts of interest that might arise as a result.
Assets, Currency and Money
The terms currency and money are used interchangeably, but they are not synonymous. The former refers to cash: paper bills in the pocket or the coins kept in a change jar. Currency is unique in appearance and value, and it varies by country. On the other hand, money represents the true value of the things that are transacted using cash. Money stores value, and the longer a ‘money item’ is held (think of an asset), the more valuable it becomes.