Financial economics is a branch of economics that deals with various financial markets, taking into consideration how resources are being used. Its particular attention to monetary activities sets it apart from the other branches.
In financial economics, important aspects that occur in forex and stock markets are analyzed, as well as how inflation, depression, deflation, recession, prices, and other financial variables impact one another. Financial economics is important in making investment decisions, identifying risks, and valuing securities and assets.
How Does Financial Economics Work?
As mentioned above, financial economics looks at the monetary activities of financial markets, making it a quantitative field. Financial economics does the following:
It is involved in analyzing the fair value of an asset and the amount of cash that can be made from an asset. Fair value is described as the actual value of a product or stock as agreed upon by both the seller and the buyer or the value of the same product given to it by the market where it is traded. In terms of cash flow, financial economics also determines how another asset or an event influences cash flow generation.
Financial economics also studies risks and identifies ways to minimize investment-related risks.
Financial economics also encompasses financial instruments such as bonds, stocks, and securities. It also looks at the various market regulations that govern the markets where these tools are traded. Of course, the markets and financial institutions are also within the purview of financial economics.
Aspects of Financial Economics
There are two basic aspects of financial economics, namely present value and risk management diversification.
1. Present Value
Every investor is aware that the value of his money today won’t be the same in the next 10 to 20 years. For example, money today will not provide the same purchasing power over the next 20 years. This is an important fact that needs to be recognized by investors when making decisions.
They should discount the 10- or 20-year difference because of inflation and risk. The discounting aspect is very important because associated problems such as underfunded pension schemes are already present.
2. Risk Management and Diversification
Risk is inherent in almost all financial activities. Anyone who keeps monitoring the stock market will notice that the stocks being traded can change trends anytime. The returns from stock investing are sometimes high, as the risk is also high. Ideally, if an investor holds two risky assets, their individual performances should compensate for the other.
Basic Concepts of Financial Economics
There are two basic concepts of Financial Economics – the Portfolio Theory and the Capital Asset Pricing Model (CAPM).
1. Portfolio Theory
Also called the Modern Portfolio Theory, this theory asserts that investors show a natural aversion to risk and will, therefore, try to avoid investments with higher risks, as well as those with lower returns. But investments with higher returns definitely come with higher risks.
Additionally, the concept believes that assets should not be treated according to how they individually perform but on how they interact with each other. This is because being able to find the correct combination of such assets can help the investor achieve the highest possible return for a certain level of risk and vice versa.
2. Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) evaluates the risks and returns that come with a risky asset in order to determine its price. Further, it proposes that the risks taken on by investors need to be countered with the appropriate compensation. It follows the following formula:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on the market
Benefits of Financial Economics
The ultimate benefit of financial economics is providing investors with the information to make sound and informed decisions in relation to their investment options. They are presented with the risks and risk factors involved in their investments, the fair value of the asset they wish to acquire, and the regulations in the financial markets where they are involved.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: