Financial economics

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as share prices, interest rates and exchange rates, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. It thus provides the theoretical underpinning for much of finance.

The subject is concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment". It therefore centers on decision making under uncertainty in the context of the financial markets, and the resultant economic and financial models and principles, and is concerned with deriving testable or policy implications from acceptable assumptions. It thus also includes a formal study of the financial markets themselves, especially market microstructure and market regulation. It is built on the foundations of microeconomics and decision theory.

Financial econometrics is the branch of financial economics that uses econometric techniques to parameterise the relationships identified. Mathematical finance is related in that it will derive and extend the mathematical or numerical models suggested by financial economics. Whereas financial economics has a primarily microeconomic focus, monetary economics is primarily macroeconomic in nature.

Financial economics studies how rational investors would apply decision theory to investment management. The subject is thus built on the foundations of microeconomics and derives several key results for the application of decision making under uncertainty to the financial markets. The underlying economic logic yields the fundamental theorem of asset pricing, which gives the conditions for arbitrage-free asset pricing. The various "fundamental" valuation formulae result directly.

Underlying all of financial economics are the concepts of present value and expectation.

Calculating their present value, ${\displaystyle X_{sj}/r}$ in the first formula, allows the decision maker to aggregate the cashflows (or other returns) to be produced by the asset in the future to a single value at the date in question, and to thus more readily compare two opportunities; this concept is then the starting point for financial decision making. (Note that here, "${\displaystyle r}$" represents a generic (or arbitrary) discount rate applied to the cash flows, whereas in the valuation formulae, the risk-free rate is applied once these have been "adjusted" for their riskiness; see below.)

An immediate extension is to combine probabilities with present value, leading to the expected value criterion which sets asset value as a function of the sizes of the expected payouts and the probabilities of their occurrence, ${\displaystyle X_{s}}$ and ${\displaystyle p_{s}}$ respectively.

This decision method, however, fails to consider risk aversion. In other words, since individuals receive greater utility from an extra dollar when they are poor and less utility when comparatively rich, the approach is therefore to "adjust" the weight assigned to the various outcomes, i.e. "states", correspondingly: ${\displaystyle Y_{s}}$. See indifference price. (Some investors may in fact be risk seeking as opposed to risk averse, but the same logic would apply.)