The Economics of Finance

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.

Difference Between Economics and Finance

The science of finance deals with the interrelation of the concepts of time, risk and money. Economics is a social science. The science of economics studies the production, consumption and distribution of services or goods.

Detailed Information

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.

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 time, uncertainty, options and / or information play roles.

Discounting, Risk Management and Diversification

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. 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.

Financial economics is the branch of economics characterized by a concentration on monetary activities, in which money of one type or another is likely to appear on both sides of a trade. Its concern is the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy.

It has two main areas of focus.

 – Asset Pricing (aka investment theory) and Corporate Finance. The first being the perspective of providers of capital, i.e. investors, and the second of users of capital.

 


 

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