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In the broader subject of economics with micro and macroeconomics, financial economics stands out as an important field of study, with mathematics playing a significant role. This branch of economics deals with various monetary activities and the financial markets. It focuses on how individuals, businesses and governments allocate resources and make financial decisions under conditions of uncertainty.
Main functions of financial economics
Financial economics studies how the different concepts listed below work together, affecting the financial market as a whole, including all stakeholders.
Topics and concepts include:
Prices - Value of assets
Inflation and deflation - Effects of changes in general price levels.
Foreign exchange rate - Rates at which one currency can be exchanged for another.
Stocks - A ownership certificate of a company
Financial portfolio - Consists of different financial investments like stocks, bonds, cash and cash equivalents
Business cycle (periods of recession and depression)
Fair value - The actual price of an asset when both the buyer and seller agree on a price.
Risk and return - Return refers to income earned from an investment. Risk refers to the uncertainty over a period of time to get this return and signifies the chances of losing money.
Financing of securities and assets - Asset refers to anything owned by the business with value (can provide monetary benefit). Security is a tradable financial asset.
Interest rates - Price to borrow money
Taxation - Paid to the government and can affect financial decisions
Investment - Allocating resources to gain returns over time.
Financial economics works closely with stock markets, financial markets and the foreign exchange rates. It helps to identifies financial risks, makes investment decisions and evaluates securities and assets. Financial economics employ various economics theories to evaluate these decisions and risks in order to provide investors with the correct information. Additionally, it utilises tools of statistics and probability.
Risk management in financial economics is a crucial function as uncertainty plays a big role in markets and businesses. This is done to correctly identify, assess and manage financial risks faced by shareholders . A part of this branch focuses on corporate finance which examines dividends policies, capital structures and how firms can maximise their value.
Financial economics also involve asset pricing, market efficiency, diversification, and discounting.
Two basic financial economics models
Capital Asset Pricing Model (CAPM)
This model estimates the return from an investment and determines if this return is worthwhile, taking into account the scenario that the investment may not perform as expected. It calculates the cost of equity, as seen in the formula below. This refers to the required rate of return for equity holders. Furthermore it takes into consideration assumptions about future returns, expertise from the stock market and risks of the market.
The model focuses on systematic risk (risk affecting the whole market), and its formula includes the risk-free rate, investment beta and the market return. Investment beta (β) compares the systematic risk of a stock or portfolio.
Portfolio Theory
The modern portfolio theory (MPT) states that for any investment the effect of its risk and return should be evaluated together, in order to create a high performance investment portfolio. By using the portfolio theory investors can create a portfolio with lower risks, higher returns and multiple assets. It is believed that this result could be achieved through diversification and choosing an optimal mix of risk and returns. The modern portfolio theory aims to help investors build a portfolio that maximises their returns for the given risk.
Conclusion
In conclusion, financial economics is a branch of economics that applies both economic and financial theories. Mathematical calculations and models also play an important role in evaluating investments and managing financial risks effectively. Financial markets require decision making and evaluating risks under conditions of uncertainty.
This branch focuses on various concepts like resource allocation, market efficiency, risks and returns and other topics discussed in the article. As well as its two main concepts of asset pricing and corporate finance. This branch is bulit on the principles of microeconomics and decision theory. Financial economics allows for the understanding of market behaviour and developing strategies for investment and financial portfolios.
Reference List
Chen, J. (2023). Fair Value. [online] Investopedia. Available at: https://www.investopedia.com/terms/f/fairvalue.asp.
Tardi, C. (2026). Financial Portfolio: What It Is, and How to Create and Manage One. [online] Investopedia. Available at: https://www.investopedia.com/terms/p/portfolio.asp#:~:text=What%20Is%20a%20Financial%20 [Accessed 27 Jun. 2024].
VEDANTU. (n.d.). Financial Economics - Methods, Models, and FAQs. [online] Available at: https://www.vedantu.com/commerce/financial-economics.
Wall Street Prep (2022). CAPM: Capital Asset Pricing Model Formula and Calculation. [online] Wall Street Prep. Available at: https://www.wallstreetprep.com/knowledge/capm-capital-asset-pricing-model/.
Wikipedia Contributors (2019). Financial economics. [online] Wikipedia. Available at: https://en.wikipedia.org/wiki/Financial_economics [Accessed 23 Oct. 2019].
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