Reviewed by Sep 30, 2020| Updated on
Financial economics is one of the branches of economics which deals with the use and distribution of financial resources. It focuses on the study of either the financial markets as a whole or individual stocks or securities. It particularly deals with monetary decisions on the allocation of financial resources in the financial market.
Financial economics employs the theory of economics to analyse the impact of financial decisions in terms of opportunity costs, expected cash flows, the market value of asset or securities, and so on.
The factors which influence financial decision making include time, the risk involved, information available (facts and legal regulations), and prices. Macro factors, such as inflation, recession, deflation, and the interest rate policy also influence decision making.
Financial economics uses various financial models for testing the numerous factors or variables which can affect decision making. The underlying assumption of the various financial models is that individuals and institutions would act rationally. However, the irrational behaviour of parties is also one of the factors influencing decision making.
Financial economics uses a lot of mathematical, statistical, and other metrics to analyse the influencing factors and evaluate risks. The portfolio theory and capital asset pricing model are used to evaluate risk and returns and determine the future value of a financial product.
Unlike traditional economics, financial economics studies financial exchanges which involve the exchange of money on both the sides of a trade. The two important aspects of financial economics are discounting, and risk management and diversification.
Discounting deals with time value of money. Whereas, risk management and diversification recognise the inherent risk in financial products, and the need to diversify and hedge risk.
The tools of financial economics aid investors to make prudent financial decisions. The tools facilitate analysis of information, such as time, rate of return, present value, and risk factors to arrive at the future value of a financial product. The tools also facilitate analysis of the impact of laws and regulations.