Financial Economics

Financial Economics

Financial economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment". It is additionally characterised by its "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". The questions within financial economics are typically framed in terms of "time, uncertainty, options, and information".

  • Time: money now is traded for money in the future.
  • Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
  • Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
  • Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value (FMV).

The subject is usually taught at a postgraduate level; see Master of Financial Economics.

Subject matter

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance.

It studies the following:

  • Valuation - Determination of the fair value of an asset
    • How risky is the asset? (identification of the asset appropriate discount rate)
    • What cash flows will it produce? (discounting of relevant cash flows)
    • How does the market price compare to similar assets? (relative valuation)
    • Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
  • Financial markets and instruments
    • Commodities - topics
    • Stocks - topics
    • Bonds - topics
    • Money market instruments- topics
    • Derivatives - topics
  • Financial institutions and regulation

Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the relationships.

Models in financial economics

Financial economics is primarily concerned with building models to derive testable or policy implications from acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect value.

A common assumption is that financial decision makers act rationally (see Homo economicus; efficient market hypothesis). However, recently, researchers in experimental economics and experimental finance have challenged this assumption empirically. They are also challenged, theoretically, by behavioral finance, a discipline primarily concerned with the limits to rationality of economic agents.

Other common assumptions include market prices following a random walk or asset returns being normally distributed. Empirical evidence suggests that these assumptions may not hold and that in practice, traders, analysts and particularly risk managers frequently modify the "standard models".

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