What Is Financial Economics?

Financial economics is a branch of economics that analyzes the use and distribution of resources in markets in which decisions are made under uncertainty. Financial decisions must often take into account future events, whether those be related to individual stocksportfolios or the market as a whole.

Key Takeaways

  • Financial economics analyzes the use and distribution of resources in markets in which decisions are made under uncertainty.
  • It employs economic theory to evaluate how time, risk (uncertainty), opportunity costs, and information can create incentives or disincentives for a particular decision.
  • Financial economics often involves the creation of sophisticated models to test the variables affecting a particular decision.

How Financial Economics Works

Making financial decisions is not always a straight-forward process. Time, risk (uncertainty), opportunity costs, and information can create incentives or disincentives. Financial economics employs economic theory to evaluate how certain things impact decision making, providing investors with the instruments to make the right calls.

Financial economics often involves the creation of sophisticated models to test the variables affecting a particular decision. Often, these models assume that individuals or institutions making decisions act rationally, though this is not necessarily the case. Irrational behavior of parties has to be taken into account in financial economics as a potential risk factor.

This branch of economics builds heavily on microeconomics and basic accounting concepts. It is a quantitative discipline that uses econometrics and other mathematical tools. It necessitates familiarity with basic probability and statistics since these are the standard tools used to measure and evaluate risk. 

Financial economics studies fair value, risk and returns, and the financing of securities and assets. Numerous monetary factors are taken into account, including interest rates and inflation.

Financial Economics Vs. Traditional Economics

Traditional economics focuses on exchanges in which money is one – but only one – of the items traded. In contrast, financial economics concentrates on exchanges in which money of one type or another is likely to appear on both sides of a trade. 

The financial economist can be distinguished from more traditional economists by their concentration on monetary activities in which time, uncertainty, options and/or information play roles. 

Financial Economics Methods

There are many angles to the concept of financial economics. Two of the most prominent are:

Discounting

Decision making over time recognizes the fact that the value of $1 in 10 years’ time is less than the value of $1 now. Therefore, the $1 at 10 years must be discounted to allow for risk, inflation, and the simple fact that it is in the future. Failure to discount appropriately can lead to problems, such as underfunded pension schemes.

Risk Management and Diversification

Many advertisements for stock market-based financial products must remind potential buyers that the value of investments may fall as well as rise, so although stocks yield a high return on average, this is largely to compensate for risk.

Financial institutions are always looking for ways of insuring, or hedging, this risk. It is sometimes possible to hold two highly risky assets but for the overall risk to be low: if share A only performs badly when share B performs well (and vice versa) then the two shares perform a perfect hedge. An important part of finance is working out the total risk of a portfolio of risky assets, since the total risk may be less than the risk of the individual components.