Economics of Finance: Definitions, Ideas, and Subjects of Study
In the realm of economics, there exists a specialized field known as financial economics. This branch of study intersects with financial studies, financial markets, and traditional economics, with a primary focus on money management, financial markets, investments, and risk assessment.
Financial economics provides a knowledge base for making decisions about money allocation, calculating return and risk, and understanding risk factors. Key concepts include modern portfolio theory, efficient-market hypothesis, risk-return tradeoff, and behavioral finance, which examines psychological influences on investor decisions and market inefficiencies.
On the other hand, traditional economics (often simply called economics) is a broader social science that studies the allocation of all kinds of resources by individuals, institutions, and governments. It focuses on topics like resource allocation, production, consumption, public policy, inflation, unemployment, and income inequality across entire economies. It uses frameworks like microeconomics (individual decisions) and macroeconomics (aggregate economic activity and policy).
Financial economics plays a key role in optimizing investment decisions, capital allocation, and pricing of financial instruments, which help allocate monetary resources efficiently within markets and support economic growth. Traditional economics informs government policy, market regulation, and addresses broader societal issues like inequality, unemployment, and economic development by studying the overall functioning of economies and resource distribution.
The value of money changes over time due to factors like inflation, and the purchasing power of money can be calculated using compound interest. For instance, the present value of $60 bills in 2030 can be calculated using a discount rate.
In financial economics, money is the object of supply and demand, and interest represents the price of money. The money supply comes from the business, household, and government sectors, with interest as the return for lenders.
One of the essential models in financial economics is the Capital Asset Pricing Model (CAPM). This model is used for evaluating the risk and return of risky assets, useful for determining benchmarks and assessing the return rate on an asset's investment. The formula for CAPM is R = R (Beta x (R- R) where R is the expected return for an asset, R is the risk-free rate, Beta is the Beta of the asset, and R is the expected market return.
Financial economics concentrates on making decisions based on risk and return, and is applied to investment decisions in financial markets. This includes analysis of an asset's fair value and the amount of cash that can be made from an investment. In a simple example, a stock of company A with a beta of 0.5 and a stock market rate of return of 12% would have an expected return of 9% [6% + 0.5 x (12% -6%)].
Moreover, financial economics involves making investment decisions, identifying risks, valuing securities and other financial assets, and understanding how economic indicators impact financial assets. Portfolio management is a concept used to optimize returns and minimize risk by diversifying and allocating money to various financial assets. Modern portfolio theory suggests that the characteristics of risk and return on investment should be evaluated in the context of the portfolio as a whole.
In essence, financial economics is a specialized branch of economics focused on financial markets and assets, while traditional economics is a broader discipline dealing with all economic activity and resource allocation in society.
Financial economics is integral in optimizing investment decisions, capital allocation, and valuing financial instruments, contributing to the efficient allocation of monetary resources within markets and supporting economic growth. Key concepts like the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory enable investors to make decisions based on risk and return, evaluate an asset's fair value, and manage portfolios to maximize returns and minimize risk.
On the other hand, traditional economics delves into broader societal issues such as inequality, unemployment, and economic development by studying the overall functioning of economies and resource distribution. It informs government policy, market regulation, and addresses challenges like inflation, resource allocation, and production.
