Financial economics

Financial economics

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Encyclopedia
Financial Economics is the branch of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 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
    Risk
    Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

    ): The amount of money to be transferred in the future is uncertain.
  • Option
    Option (finance)
    In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

    s: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
  • Information
    Perfect information
    In game theory, perfect information describes the situation when a player has available the same information to determine all of the possible games as would be available at the end of the game....

    : knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value
    Future value
    Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is the present value multiplied by the accumulation...

     (FMV).


The subject is usually taught at a postgraduate level; see Master of Financial Economics
Master of Financial Economics
A master’s degree in financial economics provides an understanding of theoretical finance and the underlying economic framework. The degree is postgraduate, and may incorporate a thesis or research component. Programs are often a joint offering by the business school and the economics department;...

.

Subject matter


Financial economics is the branch of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 studying the interrelation of financial variables
Variable (mathematics)
In mathematics, a variable is a value that may change within the scope of a given problem or set of operations. In contrast, a constant is a value that remains unchanged, though often unknown or undetermined. The concepts of constants and variables are fundamental to many areas of mathematics and...

, such as price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...

s, interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s 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:
  • 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
Financial econometrics
People working in the finance industry often use econometric techniques in a range of activities. For example in support of portfolio management, risk management and in the analysis of securities...

 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
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...

 to derive testable or policy implications from acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset Pricing Model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...

. 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
Homo economicus
Homo economicus, or Economic human, is the concept in some economic theories of humans as rational and narrowly self-interested actors who have the ability to make judgments toward their subjectively defined ends...

; efficient market hypothesis
Efficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

). However, recently, researchers in experimental economics
Experimental economics
Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in...

 and experimental finance
Experimental finance
The goals of experimental finance are to establish different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanism and returns processes...

 have challenged this assumption empirical
Empirical
The word empirical denotes information gained by means of observation or experimentation. Empirical data are data produced by an experiment or observation....

ly. They are also challenged - theoretically - by behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

, a discipline primarily concerned with the limits to rationality of economic agents.

Other common assumptions include market prices following a random walk
Random walk
A random walk, sometimes denoted RW, is a mathematical formalisation of a trajectory that consists of taking successive random steps. For example, the path traced by a molecule as it travels in a liquid or a gas, the search path of a foraging animal, the price of a fluctuating stock and the...

, or asset returns being normally distributed. Empirical evidence suggests that these assumptions may not hold, and in practice, traders and analysts, and particularly risk managers
Financial risk management
Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...

, frequently modify the "standard models".

See also



Theory

  • Foundations of Finance, Theory of Finance, Eugene Fama
    Eugene Fama
    Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...

    , University of Chicago Graduate School of Business
  • Macro-Investment Analysis, Professor William Sharpe
    William Forsyth Sharpe
    William Forsyth Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business and the winner of the 1990 Nobel Memorial Prize in Economic Sciences....

    , Stanford Graduate School of Business
    Stanford Graduate School of Business
    The Stanford Graduate School of Business is one of the professional schools of Stanford University, in Stanford, California and is broadly regarded as one of the best business schools in the world.The Stanford GSB offers a general management Master of Business Administration degree, the Sloan...

  • Lecture Notes in Financial Economics, Antonio Mele, London School of Economics
    London School of Economics
    The London School of Economics and Political Science is a public research university specialised in the social sciences located in London, United Kingdom, and a constituent college of the federal University of London...

  • Great Moments in Financial Economics I, II, ; IVa; . Prof. Mark Rubinstein
    Mark Rubinstein
    Mark Edward Rubinstein is a leading financial economist and financial engineer. He is currently Professor of Finance at the Haas School of Business of the University of California, Berkeley, where he is involved in teaching courses in the , an academic program that is focused on equipping...

    , Haas School of Business
    Haas School of Business
    The Walter A. Haas School of Business, also known as the Haas School of Business or simply Haas, is one of 14 schools and colleges at the University of California, Berkeley....

  • Microfoundations of Financial Economics Prof. André Farber Solvay Business School
  • Handbook of the Economics of Finance, G.M. Constantinides, M. Harris, R. M. Stulz
  • Financial economics, International Encyclopedia of the Social & Behavioral Sciences
    International Encyclopedia of the Social & Behavioral Sciences
    The International Encyclopedia of the Social & Behavioral Sciences , edited by Neil J. Smelser andPaul B. Baltes, is a 26-volume work. It has some 4,000 signed articles, commissioned by around 50 subject editors, and includes biographical entries, 122,400 entries, and an extensivehierarchical...

    , Oxford: Elsevier, 2001.
  • Financial economics topics with Abstracts, The New Palgrave Dictionary of Economics
    The New Palgrave Dictionary of Economics, 2nd Edition
    The New Palgrave Dictionary of Economics , 2nd Edition, is an eight-volume reference work, edited by Steven N. Durlauf and Lawrence E. Blume. It contains 5.8 million words and spans 7,680 pages with 1,872 articles. Included are 1057 new articles and, from earlier, 80 essays that are designated as...

    , 2008.
  • An introduction to investment theory, Prof. William Goetzmann, Yale School of Management
    Yale School of Management
    The Yale School of Management is the graduate business school of Yale University and is located on Hillhouse Avenue in New Haven, Connecticut, United States. The School offers Master of Business Administration and Ph.D. degree programs. As of January 2011, 454 students were enrolled in its MBA...

  • Notes on General Equilibrium Asset Pricing, Prof. Paulo Brito, ISEG, Technical University of Lisbon
    Technical University of Lisbon
    The Technical University of Lisbon is a Portuguese public university. It was created in 1930 in Lisbon, as a confederation of older schools, and comprises, nowadays, the faculties and institutes of veterinary medicine; agricultural sciences; economics and business administration; engineering,...


Context and history

  • Finance Theory, The History of Economic Thought Website, The New School
    The New School
    The New School is a university in New York City, located mostly in Greenwich Village. From its founding in 1919 by progressive New York academics, and for most of its history, the university was known as the New School for Social Research. Between 1997 and 2005 it was known as New School University...

  • The Scientific Evolution of Finance Prof. Don Chance, Prof. Pamela Peterson
  • 50 Years of Finance Prof. André Farber, Université Libre de Bruxelles
    Université Libre de Bruxelles
    The Université libre de Bruxelles is a French-speaking university in Brussels, Belgium. It has 21,000 students, 29% of whom come from abroad, and an equally cosmopolitan staff.-Name:...

    , Professor Michael Phillips, California State University, Northridge
    California State University, Northridge
    California State University, Northridge is a public university in Northridge, a neighborhood in the San Fernando Valley area of Los Angeles, California, United States....

  • Pioneers of Finance, Prof. Larry Guin, Murray State University
    Murray State University
    Murray State University, located in the city of Murray, Kentucky, is a four-year public university with approximately 10,400 students. The school is Kentucky’s only public university to be listed in the U.S.News & World Report regional university top tier for the past 20 consecutive years...


Links and portals