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 stocks, portfolios or the market as a whole.

BREAKING DOWN 'Financial Economics'

Financial economics 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. 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.

While traditional economics focuses on exchanges in which money is one, but only one, of the items traded, 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 his or her concentration on monetary activities in which timeuncertaintyoptions and/or information play roles. 

Discounting, Risk Management and Diversification in Financial Economics

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.

Financial economics builds heavily on microeconomics and basic accounting concepts. It also necessitates familiarity with basic probability and statistics, since these are the standard tools used to measure and evaluate risk. 

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