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Financial economics

Financial economics is the branch of economics concerned with the workings of financial markets, such as the stock market, and the financing of companies. It can be distinguished from other branches of economics 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 addressed are typically framed in terms of "time, uncertainty, options and information". [1]

  • 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.

Financial economics attempts to answer questions such as:

  • How are the prices of financial assets, such as stocks and bonds, determined?
  • 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?

In recent decades, a lot of work has concerned itself with the prices of derivative securities, financial instruments that derive their value from other, underlying, assets. Stock options are a classic form of derivative -- Fischer Black, Myron S. Scholes, and Robert C. Merton did ground-breaking work in the early 1970s on the determination of stock option prices on the basis of the underlying stock's price and volatility.

The work soon proved to have widespread applications, and helped inspire the creation of ever more complicated derivatives, (swaps, swaptions, etc.) which in turn has kept theorists busy building newer models.

The underlying point behind all the model construction is that of finding a value that arbitrage will enforce. Arbitrage is always a self-terminating activity -- it brings prices to a level at which it can no longer occur.

Important concepts: Risk free rate, Time value of money, Fisher separation theorem, Modigliani-Miller theorem, Arbitrage, Rational pricing, Efficient markets theory, Modern portfolio theory

See also: Finance, Financial mathematics, Mathematical economics, Model (economics)

References: Professor William Sharpe:"Macro-Investment Analysis"

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Last updated: 10-24-2004 05:10:45