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Financial economics

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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" [1]. 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" [2]. The questions within Financial economics are typically framed in terms of "time, uncertainty, options and information" [3].

  • 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).

Subject matter

Given its scope, as above, financial economics tends to deal with the workings of financial markets, such as the stock market, and the financing of companies, and includes the following subject areas: Budgeting, saving, investing, borrowing, lending, insuring, hedging, diversifying, and asset management. Because the future is never known with certainty, a central concern of financial economics is the impact of uncertainty on resource allocation.

Financial economics thus attempts to answer questions such as:

  • How are the prices of financial assets determined (stocks, bonds, currencies, commodities, and derivatives)?
  • What are the effects of a company choosing different methods of financing its operations, such as issuing shares or borrowing?
  • What portfolio of assets should an investor hold in order to best meet his/her objectives?

Financial Models

Financial economics is primarily concerned with building models to derive testable implications from acceptable assumptions. A common assumption is that financial decision makers act rational (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 in practice, traders and analysts, and particularly risk managers, frequently modify the "standard models".

While in economics models are mainly employed to judge social welfare, financial economists are more concerned with empirical predictions.

Important concepts

Finance journals

See also

Theory

Context and history

Links and portals

Education

Master's degrees in financial economics are often a joint offering by the business school and the economics department.

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