What is financial economics?
Financial economics is a branch of economics that analyzes the use and distribution of resources in markets. Financial decisions often have to take into account future events, whether they relate to individual stocks, portfolios or the market as a whole.
Key points to remember
- Financial economics analyzes the use and distribution of resources in markets.
- It uses economic theory to assess how time, risk, opportunity costs, and information can create incentives or disincentives for a particular decision.
- Financial economics often involves creating sophisticated models to test the variables affecting a particular decision.
How the financial economy works
Making financial decisions is not always a straightforward process. Time, risk (uncertainty), opportunity costs and information can create incentives or disincentives. Financial economics uses economic theory to assess the impact of certain things on decision-making, providing investors with the tools to make the right choices.
Financial economics generally involves the creation of sophisticated models to test the variables affecting a particular decision. Often, these models assume that the individuals or institutions that make decisions act rationally, although this is not necessarily the case. The irrational behavior of the parties must be taken into account in the financial economy as a potential risk factor.
This branch of economics relies heavily on microeconomics and basic accounting Notions. It is a quantitative discipline that uses econometrics as well as other mathematical tools.
Financial economics requires familiarity with basic probability and statistics, as these are the standard tools used to measure and assess risk.
Financial economics studies fair value, risks and returns, as well as the financing of securities and assets. Many monetary factors are also taken into account, including interest rates and inflation.
Financial economics vs traditional economics
Traditional economics focuses on exchanges in which money is a–but only one–of exchanged items. In contrast, financial economics focuses on exchanges in which money of one type or another is likely to appear on both sides of a transaction.
The financial economist differs from traditional economists by their focus on monetary activities in which time, uncertainty, options and information play a role.
Financial economics methods
The concept of financial economics has many angles. Two of the most important are:
Decision making over time recognizes that the value of $ 1 in 10 years is less than the value of $ 1 now. Therefore, the $ 1 to 10 years must be discounted to account for risk, inflation, and the simple fact that it is in the future. Lack of proper discounting can lead to problems, such as underfunded pension plans.
Risk management and diversification
Advertisements for stock market financial products should remind potential buyers that the value of investments can go down as well as up.
Financial institutions are always looking for ways to insure or cover this risk. It is sometimes possible to hold two very risky assets, but so that the overall risk is low: if share A only behaves badly when share B behaves well (and vice versa) then the two shares achieve perfect hedging.
An important part of finance is calculating the total risk of a portfolio of risky assets, as the total risk may be less than the risk of the individual components.