Financial economics
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Financial economics is the branch of economics concerned with the workings of financial markets, such as the stock market, and the financing of companies. It can be distinguished from other branches of economics by its "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade." The questions addressed are typically framed in terms of "time, uncertainty, options and information" [link].
- Time: money now is traded for money in the future.
- Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
- Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
- Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value.
- How are the prices of financial assets: stocks, bonds, currencies, and commodities, determined?
- What are the effects of a company choosing different methods of financing its operations, such as issuing shares or borrowing?
- What portfolio of assets should an investor hold in order to best meet his/her objectives?
The work soon proved to have widespread applications, and helped inspire the creation of ever more complicated derivatives, (swaps, swaptions, etc.) which in turn has kept theorists busy building newer models.
The underlying point behind all the model construction is that of finding a value that arbitrage will enforce. Arbitrage is always a self-terminating activity -- it brings prices to a level at which it can no longer occur. At a certain useful level of abstraction, arbitrage is said to terminate so quickly that it never happens at all, even if some traders do have private information. See no-trade theorem. But real markets have various sorts of friction that inhibit that ideal operation.
Financial economics is based on some hypothesis. However, recently, researchers in Experimental economics and Experimental finance have challenged those assumptions by conducting some experiments to observe people's behavior and decision-making. Experiments are often conducted in the Laboratory, by a simulation software, etc.
The top 3 finance journals are Journal of Finance, Review of Financial Studies and the Journal of Financial Economics. Pathbreaking research is also published in Econometrica.
Important concepts
- Risk-free interest rate
- Time value of money
- Fisher separation theorem
- Modigliani-Miller theorem
- Arbitrage
- Rational pricing
- Efficient market theory
- Modern portfolio theory
- Yield curve
- Homo economicus
- Arrow-Debreu model
See also
- Finance
- Value investing
- Financial mathematics
- Financial engineering
- Mathematical economics
- Model (economics)
- Experimental economics
- Experimental finance
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External links and references
- ["Macro-Investment Analysis"], Professor William Sharpe, Stanford Graduate School of Business
- [Great Moments in Financial Economics I], [II], [III], Prof. Mark Rubinstein, Haas School of Business
- [Finance Theory], The History of Economic Thought Website, The New School
- [A Short History of Investment Forecasting], Professor Michael Phillips, California State University, Northridge
- [Pioneers of Finance], Prof. Larry Guin, Murray State University
- [How Modern is Modern Portfolio Theory?], Peter Bernstein
- [Fallacies of Financial Economics], John Oswin Schroy, capital-flow-analysis.com
- [Financial Economics], greekshares.com
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