Encyclopedia of Finance

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The need for serious coverage of financial modeling has never been greater, especially with the size, diversity, and efficiency of modern capital markets. With this in mind, the Encyclopedia of Financial Models, 3-Volume Set has been created to help professionals in the demanding field of finance understand the various models currently available and apply them in real-world situations. This 3-Volume Set contains information on both the fundamentals of, and advances in, financial modeling and addresses the mathematical and statistical techniques needed to develop and test financial models.

If you do not receive an email within 10 minutes, your email address may not be registered, and you may need to create a new Wiley Online Library account. If the address matches an existing account you will receive an email with instructions to retrieve your username. Skip to Main Content. Due to the problems just noted, the majority of ordinary consumers refrain from engaging in financial markets on their own and instead rely on the services of financial intermediaries, such as banks, investment funds, and insurance companies. But this opens up new ethical problems that are due to the conflicts of interest inherent in financial intermediation.

Interestingly, some argue that the whole industry of actively managed investment funds may be seen as a form of fraud. According to economic theory, namely, it is impossible to beat the average returns of the market for any given level of financial risk, at least in the long term. Therefore, funds who claim that they can do this for a fee are basically cheating their clients cf. Hendry , Kay The interests referred to are typically taken to be financial interests, so the obligation of the fiduciary is basically to maximize investment returns.

In any case, it is often thought that fiduciary duties go beyond the ideal of a free market to instead give stronger protection to the weaker party of a fragile relationship. As an alternative or compliment to fiduciary duty, some argue for the adoption of a code of ethics or professional conduct by financial professionals. A code of ethics would be less arduous in legal terms and is therefore more attractive to free market proponents Koslowski It can also cover other fragile relationships including those of bank-depositor, advisor-client, etc.

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It is also unclear whether finance can be regarded as a profession in the traditional sense, which typically requires a body of specialized knowledge, high degrees of organization and self-regulation, and a commitment to public service Boatright , Herzog forthcoming. Probably the most well-known ethical problem concerning fairness in finance, and also perhaps the one on which philosophers most disagree, is so-called insider trading.

Put simply, this occurs when an agent uses his or her position within, or privileged information about, a company to buy or sell its shares or other related financial assets at favorable times and prices. For example, a CEO may buy shares in his or her company just before it announces a major increase in earnings that will boost the share price. While there is no fraud or breach of fiduciary duty, the agent seems to be exploiting an asymmetry of information.

Just as in the cases above, it is difficult to give an exact definition of insider trading, and the scope of its operative definition tends to vary across jurisdictions. Indeed, some argue that even stock analysts or journalists can be regarded as insiders if they trade on information that they have gathered themselves but not yet made publicly available. It is also debatable whether an actual trade has to take place or whether insider trading can consist in an omission to trade based on inside information, or also in enabling others to trade or not trade Koslowski Several philosophical perspectives have been used to explain what if anything is wrong with insider trading.

A first perspective invokes the concept of fair play. Even in a situation with fully autonomous traders, the argument goes, market transactions are not fair if one party has access to information that the other has not. However, critics argue that this perspective imposes excessive demands of informational equality. There are many asymmetries of information in the market that are seemingly unproblematic, e.

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So might it be the inaccessibility of inside information that is problematic? But against this, one could argue that, in principle, outsiders have the possibility to become insiders and thus to obtain the exact same information Lawson , Moore A second perspective views insider trading as a breach of duty, not towards the counterparty in the trade but towards the source of the information. US legislation treats inside information as the property of the underlying company and, thus, insider trading is essentially a form of theft of corporate property often called the misappropriation theory Lawson A related suggestion is that it can be seen as a violation of the fiduciary duty that insiders have towards the company for which they work Moore However, critics argue that the misappropriation theory misrepresents the relationship between companies and insiders.

On the one hand, there are many normal business situations in which insiders are permitted or even expected to spread inside information to outside sources Boatright A third perspective deals with the effects, both direct and indirect, of allowing insider trading. Interestingly, many argue that the direct effects of such a policy might be positive.

Since insider trading contributes important information, it is likely to improve the process of price discovery Manne However, others express concern over the indirect effects, which are likely to be more negative. Allowing insider trading may erode the moral standards of market participants by favoring opportunism over fair play Werhane We will now move on to take a societal view on finance, and discuss ideas relating to the broader social responsibilities of financial agents, that go beyond their basic role as market participants.

We will discuss three such ideas here, respectively focusing on systemic risk a responsibility to avoid societal harm , microfinance a responsibility towards the poor or unbanked , and socially responsible investment a responsibility to help address societal challenges. One root cause of the financial crisis of was the very high levels of risk-taking of many banks and other financial agents. When these risks materialized, the financial system came to the brink of collapse.

Many governments stepped in to bail out the banks and in consequence sacrificed other parts of public spending. This is a prime example of how certain financial activities, when run amok, can have devastating effects on third parties and society in general. The concept of systemic risk gives rise to several prominent ethical issues. To what extent do financial agents have a moral duty to limit their contributions to systemic risk? But the important point about systemic risk is that financial crises have negative effects on third parties so-called externalities.

This constitutes a prima facie case for a duty of precaution on the part of financial agents, based on the social responsibility to avoid causing unnecessary harm James , Linarelli In cases where precaution is impossible, one could add a related duty of rectification or compensation to the victims of the harm James It is, however, a matter of philosophical dispute whether finance professionals can be held morally responsible for these harms de Bruin A duty of precaution may here be taken to imply, e.

As an alternative to the reasoning above, one may argue that the duty of precaution is more properly located on the collective, i. We return to this suggestion below in section 5.

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Even in normal times, people with very low income or wealth have hardly any access to basic financial services. Moreover, there will likely be cases where some bank officers discriminate against underprivileged groups, even where extensive legal protection is in place. The initiative started in some of the poorest countries of the world, such as Bangladesh and India.

The justifications offered for microfinance are similar to the justifications offered for development aid. A popular justification holds that affluent people have a duty of assistance towards the poor, and microfinance is thought to be a particularly efficient way to alleviate poverty Yunus , But is this correct? Another justification holds that there is a basic human right to subsistence, and that this includes a right to savings and credit Hudon , Meyer Microfinance is of course different from development aid in that it involves commercial banking relations.

This invites the familiar political debate of state- versus market-based support. According to critics, however, it is the other way around: Markets will tend to breed greed and inequality, whereas real development is created by large-scale investments in education and infrastructure Bateman , H. Weber Socially responsible investment refers to the emerging practice whereby financial agents give weight to putatively ethical, social or environmental considerations in investment decisions—e. But more commonly, it is perceived as an alternative to mainstream investment.

The background argument here is that market pricing mechanisms, and financial markets in particular, seem to be unable to promote sufficient levels of social and environmental responsibility in firms. Even though there is widespread social agreement on the evils of sweatshop labor and environmental degradation, for instance, mainstream investors are still financing enterprises that sustain such unjustifiable practices. The simplest and most common approach among these alternative investors is to avoid investments in companies that are perceived to be ethically problematic.

The deontological perspective above has been criticized for being too black-and-white. On the other hand, the relationship between the investor and the investee is not as direct as one may think. To the extent that investors buy and sell shares on the stock market, they are not engaging with the underlying companies but rather with other investors.


However, such more complicated philosophical positions have problems of their own see also rule consequentialism and collective responsibility. Of course, the flip side of such practices, which may explain why they are less common in the market, is that they invite greater financial risks Sandberg It remains an open question whether socially responsible investment will grow enough in size to make financial markets a force for societal change.

Discussions about the social responsibility of finance are obviously premised on the observation that the financial system forms a central infrastructure of modern economies and societies. As we noted at the outset, it is important to see that the system contains both private elements such as commercial banks, insurance companies, and investment funds and public elements such as central banks and regulatory bodies.

However, issues concerning the proper balance between these elements, especially the proper role and reach of the state, are perennially recurrent in both popular and philosophical debates. The discussions around finance in political philosophy can be grouped under three broad areas: financialization and democracy; finance, money and domestic justice; and finance and global justice. We consider these now in turn.

A related normative concern is the potential growth in political power of the financial sector, which may be seen as a threat to democratic politics. Barry ; Christiano , To take one recent version of these worries, Stuart White argues that a republican commitment to popular sovereignty is in significant tension with the acceptance of an economic system where important choices about investment, and hence the direction of development of the economy, are under the control of financial interests White In many such debates, the fault-line seems to be the traditional one between those who favor social coordination by free markets, and hence strict limitations on state activities, and those who favor democratic politics, and hence strict limitations on markets without denying that there can be intermediate positions.

But the current financial system is not a pure creature of the free market. In addition, current legal systems find it difficult to impose accountability for complex processes of divided labor, which is why there were very few legal remedies after the financial crisis of e.

The lack of accountability intensifies worries about the power relations between democratic politicians and individuals or corporations in the financial realm. One question is whether we can even apply our standard concept of democracy to societies that have the kinds of financial systems we see today. For example, states with high levels of sovereign debt will need to consider the reaction of financial markets in every significant policy decision see, e. This is similar to the problems of conflicts of interest raised above see sections 2 and 4.

If financial contracts become a central, or maybe even the most central, form of social relations Lazzarato , this may create an incompatibility with the equal standing of citizens, irrespective of financial position, that is the basis of a democratic society. While finance has, over long stretches of history, been rather strictly regulated, there has been a reversed trend towards reregulation since roughly the s.

After the financial crisis of , there have been many calls for reregulation. However, given that the financial system is a global system, one controversial question is whether regulatory steps by single countries would have any effect other than capital flight. When it comes to domestic social justice, the central question relating to the finance system concerns the ways in which the realization of justice can be helped or hindered by how the financial system is organized.

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A first question here, already touched upon in the discussion about microfinance above section 4. Should they all have a right to certain financial services such as a bank account or certain forms of loans, because credit should be seen as a primary good in capitalist economies see, e. This is not only an issue for very poor countries, but also for richer countries with high economic inequality, where it becomes a question of domestic justice. In some countries all residents have the right to open a basic bank account see bank accounts in the EU in Other Internet Resources.

For others this is not the case. It has been argued that not having access to basic financial services creates an unfairness, because it drives poorer individuals into a cash economy in which they are more vulnerable to exploitative lenders, and in which it is more difficult to build up savings e. Hence, it has been suggested either to regulate banking services for individuals more strictly e. Secondly, financialization may also have more direct effects on socio-economic inequality. Those with managerial positions within the financial sector are disproportionately represented among the very top end of the income distribution, and so the growth of inequality can in part be explained by the growth in the financial sector itself Piketty As Dietsch et al.

Thirdly, many debates about the relation between distributive justice and the financial system revolve around the market for mortgages, because for many individuals, a house is the single largest item for which they need to take out a loan, and their mortgage their main point of interaction with the financial system.

This means that the question of who has access to mortgage loans and at what price can have a major impact on the overall distribution of income and wealth. In addition, it has an impact on how financial risks are distributed in society. Highly indebted individuals are more vulnerable when it comes to ups and downs either in their personal lives e. The danger here is that existing inequalities—which many theories of justice would describe as unjust—are reinforced even further Herzog a. Here, however, a question about the institutional division of labor arises: which goals of distributive justice should be achieved within markets—and specifically, within financial markets—and which ones by other means, for example through taxation and redistribution?

The latter has been the standard approach used by many welfare systems: the idea being to let markets run their course, and then to achieve the desired patterns of distribution by taxation and redistribution. If one remains within that paradigm, questions arise about whether the financial sector should be taxed more highly. This could, for example, mean regulating banking services and credit markets in ways that reduce inequality, for example by imposing regulations on payday lenders and banks, so that poor individuals are protected from falling into a spiral of ever higher debt.

A more radical view could be to see the financial problems faced by such individuals as being caused by more general structural injustices the solution of which does not necessarily require interventions with the financial industry, but rather more general redistributive or predistributive policies. Money creation: Another alternative theoretical approach is to integrate distributive concerns into monetary policy, i.

So far, central banks have focused on the stability of currencies and, in some cases, levels of employment. This technical focus, together with the risk that politicians might abuse monetary policy to try to boost the economy before elections, have been used in arguments for putting the control of the money supply into the hands of technical experts, removing monetary policy from democratic politics. This raises new questions of justice: are such measures justified if their declared aim is to move the economy out of a slump, which presumably also helps disadvantaged individuals Haldane ?

And if such measures are used, is it still appropriate to think of central banks as institutions in which nothing but technical expertise is required, or should there be some form of accountability to society? We have already discussed the general issue of the ontological status of money section 1. But there are also significant questions in political philosophy regarding the question of where, and by what sorts of institution, should the money supply be controlled.


One complicating factor here is the extensive disagreement about the institutional basis of money creation, as described above. However, the relationship between private commercial banks and the central bank is a complicated one, such that we might best think of money creation as a matter involving a kind of hybrid public-private partnership.

When the curious public-private nature of money creation is brought into focus, it is not surprising that there should exist views advocating a shift away from this hybrid monetary constitution, either in the direction of a fully public option, or a fully private system of money creation. Advocates of fully public banking envisage a system in which private banks are stripped of their authority to create new money, and where instead the money supply is directly controlled either by the government or by some other state agency; for example by the central bank lending directly to firms and households.

Finally, a number of issues relate questions about finance to questions about global justice. The financial system is one of the most globalized systems of social interaction that currently exist, and global entanglements are hard to deny e.

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The question thus is whether this creates duties of justice on the financial system, and if so, whether it fulfills these duties, i. There are a number of institutions, especially the World Bank and the International Monetary Fund IMF , that constitute a rudimentary global order of finance. Arguably, many countries, especially poorer ones, cannot reasonably opt out of the rules established by these institutions e.

It might therefore appear to be required by justice that these institutions be governed in a way that represents the interests of all countries. But because of historical path-dependencies, and because a large part of their budget comes from Western countries, the governance structures are strongly biased in their favor for example, the US can veto all important decisions in the IMF. An issue worth noting in this context is the fact that the US dollar, and to a lesser degree the Euro, function as de facto global currencies, with a large part of global trade being conducted in these currencies e.

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This allows the issuing countries to run a current account deficit, which amounts to a redistribution from poorer to richer countries for which compensation might be owed Reddy —5. This fact also raises questions about the distribution of power in the global sphere, which has often been criticized as favoring Western countries e. However, global financial markets serve not only to finance trade in goods and services; there are also questions about fluctuations in these markets that result exclusively from speculations see also sect.

Such fluctuations can disproportionately harm poorer countries, which are more vulnerable to movements of capital or rapid changes in commodity prices. As Pogge describes e. This means that rogue governments can finance themselves by incurring debts that future generations of citizens will have to repay. Sovereign debt raises a number of questions that are related to global justice. Usually, the contracts on which they are based are considered as absolutely binding e. Such cases have been at the center of calls for a jubilee for indebted nations. At the moment, there are no binding international rules for how to deal with sovereign bankruptcy, and countries in financial distress have no systematic possibility of making their claims heard, which is problematic from a perspective of justice e.

The Editors' wish is that the readers will find the encyclopedia to be an invaluable resource. He has maintained academic and consulting ties in Taiwan, Hong Kong, China and the United States for the past three decades. In the winter issue of the Journal of Finance Literature, Professor Lee was ranked as the most published finance professor worldwide during Professor Alice C.

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