Mathematical Techniques in Finance

CHAPTER 1Finance

While economics as a social science studies the behavior of economic agents in the generation, acquisition, and expenditure of goods and services, finance is focused on the acquisition and management of capital in financial markets.

Focusing on the end user, finance can be divided into personal finance, corporate finance, and government finance. Savings, investments, and loans, such as credit card, student, automobile, and home mortgage, insurance products, and estate planning are examples of personal finance. The raising of capital by borrowing and debt or selling shares and equity by a company and the management of a company's funds are the focus of corporate finance. Monetary policy, central banking, tax systems, and the oversight of the banking sector and financial markets fall under government finance.

1.1 FOLLOW THE MONEY

Using the reductive definition of finance as the study of money, we follow the money to get our bearings. In accounting, a balance sheet is a snapshot of an entity's (person, corporation, country) net worth or equity: assets minus liabilities equals equity. Table 1.1 shows a snapshot of the net worth of the three dominant players in the U.S. economy: households, firms, and government.

As the table shows, households hold the largest amount of equity, followed by firms, while the U.S. government runs a negative balance and is in debt. Indeed, the U.S. government is the world's biggest borrower and routinely borrows money to finance its ...