Financial economics is one of the many branches of economics that deals with various financial markets, taking into consideration how resources are being used. Its particular attention to monetary activities mostly sets it apart from the other branches.
In financial economics, important aspects that occur especially in forex and stock markets are analyzed, as well as how inflation, depression, deflation, recession, prices, and more impact one another. Financial economics is important, especially in making investment decisions, identifying risks, and valuing securities and assets.
As mentioned above, financial economics looks more at the monetary activities of financial markets, making it a quantitative field. Financial economics does the following:
There are two basic aspects of financial economics, namely discounting and risk management diversification.
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. It 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.
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, and it is the most effective way to lure investors to buy and trade the stocks. Ideally, if an investor holds two risky assets, their individual performances should compensate for the other.
There are two basic concepts of Financial Economics – the Portfolio Theory and the Capital Asset Pricing Model (CAPM).
Also called the Modern Portfolio Theory, it believes 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. Thus, 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. It 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.
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 market
The ultimate benefit of financial economics is providing investors with the instruments 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, as well as the various financial institutions.
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 resources will be helpful: