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Financial Economics

Financial economics is a branch of economics that is applied to the financial markets, such as the forex and stock markets. It studies the relationship among financial variables, such as prices, inflation and interest rates. Financial economics focuses on the impact of economic variables, such as GDP (gross domestic product) and CPI (consumer price index), on the financial markets. It involves building models based on the two key concepts of uncertainty and the time value of money. This branch of economy differs from others due to the emphasis on the study of "monetary activities."

How does Financial Economics Work?

Financial economics is a highly quantitative field. It studies the fair value of an asset by evaluating the associated risk factors, cash generated by the asset and whether the cash flow generation is dependent on an event or another asset. It also considers the asset’s market price as compared to that of similar assets while studying the asset’s fair value.

Moreover, financial economics studies financial instruments, such as bonds, commodities and stocks, the markets in which these instruments are traded, the financial institutions and market regulations.

The basic concepts of financial economics revolve around the Portfolio Theory and the Capital Asset Pricing Model.

The Portfolio Theory propagates the minimization of the risk profile of an investment portfolio through the diversification of investment capital. Based on the assumption that investors are generally averse to risks, this theory focuses on the valuation of securities, allocation of resources (assets), optimization of portfolio and measurement of portfolio performance to maximize returns.

The Capital Asset Pricing Model (CAPM) helps in determining the price of a risky security by evaluating the associated risks and expected returns. This model takes into consideration that investors must be compensated for the risks they are undertaking and the time value of money. According to CAPM, the expected return from a security is the sum of the rate on a risk-free security and a risk premium. If this expected return is not equal to or higher than the required return from the security, then the investment is worthless.

Benefits of Financial Economics

Financial economics helps investors make more informed decisions about investment options.

Drawbacks of Financial Economics

Propagating “practical know-how and empirical tricks,” financial derivatives specialist Nassim Nicholas Taleb said, “The environment in financial economics is reminiscent of medieval medicine, which refused to incorporate the observations and experiences of the plebeian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk.”


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