Financial economics is a branch of economics that analyzes how resources are used and distributed in markets. In general, it is the study of choices consumers, business managers, and government officials make to achieve their goals considering that they have limited or scarce resources. Financial decisions will frequently have to take into consideration future events, which can be related to individual stocks, portfolios, or the market as a whole. Financial economics differs from the other branches of economics because it pays particular attention to monetary activities. This branch of economics analyzes how inflation, depression, deflation, recession, prices, and other financial variables impact one another. It applies economic principles to financial markets, corporations, banks, and central banking policies, and uses economic theory to evaluate how time, risk, opportunity costs, and information can produce incentives for a particular decision. Financial economics plays an important role in making investment decisions, identifying risks, and valuing securities and assets.
How Financial Economics Works
Financial economics is a quantitative field because it examines the monetary activities of financial markets. It uses econometrics in addition to other mathematical tools, and builds heavily on microeconomics and basic accounting concepts. This branch of economics requires familiarity with basic probability and statistics since these are the tools which are typically used to measure and evaluate risk. Financial economics does the following:
It studies the fair value of an asset and the amount of cash that can be produced from an asset. Fair value refers to the actual value of a product or stock as agreed upon by the seller as well as the buyer or the value of the same product given to it by the market where it is traded. Regarding cash flow, financial economics also determines how another asset or an event influences cash flow generation.
Financial economics studies risks and determines ways to minimize investment-related risks.
Financial economics involves financial instruments including bonds, stocks, and securities. It also examines the different market regulations that control the governments where these tools are traded. Financial economics also encompasses the markets and financial institutions.
Financial Economics vs. Traditional Economics
Traditional economics pays particular attention to exchanges in which money is one—but only one—of the items traded. On the other hand, financial economics focuses on exchanges in which money of one type or another will likely appear on both sides of a trade.
Financial economists differ from traditional economists because they concentrate on monetary activities in which time, uncertainty, options, and information play roles.
Aspects of Financial Economics
Financial economics has two basic aspects: present value and risk management and diversification.
Present Value
Every investor knows that the value of his money today will not be the same in the next 10 to 20 years. For instance, money today will not provide the same purchasing power over the next 20 years. Investors need to acknowledge this crucial fact when making decisions.
They should discount the 10- or 20-year difference due to inflation and risk. The discounting aspect is critical because associated problems already exist.
Risk Management and Diversification
Risk is an essential part of nearly all financial activities. Anybody who constantly monitors the stock market will notice that the stocks being traded can change trends anytime. Since the risk is high, the returns from stock investing are sometimes high. If an investor holds two risky assets, their individual performances should make up for the other.
Benefits of Financial Economics
The ultimate benefit of financial economics is that it provides investors with the information they need to make sound and informed decisions with regards to their investment options. They are presented with the risks and risk factors involved in their investments, the fair value of the asset they want to acquire, and the regulations in the financial markets where they are involved.
Asset: An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a benefit in the future.
Deflation: Deflation is a general decline in prices for goods and services, commonly associated with a contraction in the supply of money and credit in the economy. The purchasing power of currency rises over time during deflation.
Opportunity cost: Opportunity cost is the value of what an individual, investor, or business loses when choosing between two or more options.
Portfolio: A portfolio is a collection of financial assets and could include stocks, bonds, cash and cash equivalents, or alternative investments.
Risk management: Risk management is the process of identifying, analyzing, and accepting or mitigating uncertainty in investment decisions.
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