Financial economics study about the financial variables which concern the real economy. It is concerned with the allocating and deploying of economic resources while managing resources for uncertainty. It uses various economic theories to analyse risks and opportunity costs. Financial economics is based on macroeconomics and basic concepts of finance.
Understanding Financial Economics
How Does Financial Economics Work?
Financial economics considers the quantitative aspects of the financial market like inflation, deflation, boom, recession, prices, and many other financial variables. It works as:
It looks after any uncertainty or risk that may arise and tries to minimise these risks related to investments.
It considers the market regulations where financial instruments like bonds and securities are traded. It all comes under financial economics.
How Does Financial Economics work?
Why do We Study Financial Economics and Its Use?
Finance and Economics have an impact on everyone’s life. People are involved in production, consumption, use of goods and services, and also managing the issues of scarcity. Financial Economics gives a deep understanding of the fundamentals of economics, its impact, use in the decision-making process by linking it with quantitative aspects of finance. Studying financial economics helps in making rational decisions and working towards a bigger goal with proper forecasting and plans. Also, studying financial economics helps in career growth prospects which includes getting jobs in the field of economics, accounting, analysis, and consulting services. This domain has a huge score for individuals as well as society at large.
Methods of Financial Economics
In financial economics, there are many methods of getting to the concept, but the most prominent of them are the following:
It is a process of converting a value which will be received in future to the same value which can be received immediately. The Rs 1 received today is not the same as received after 10 years. We need to take into consideration the time value of money.
Risk can be managed by diversifying the portfolio. It is spreading your investments around to reduce its risk exposure. Through diversification, unsystematic risk can be mitigated.
Models of Financial Economics
There are two basic models/concepts of financial economics which are a) Capital Asset Pricing Model (CAPM) and b) Portfolio Theory.
Capital Asset Pricing Model (CAPM)
According to CAPM, investments are valued, and decisions are made on the basis of the time value of money, the risk involved, and the expected return. It is assumed that all the investors have similar expectations of both risk and return. Here, diversification is done to get more returns.
It is a method where investments are selected for maximising the overall returns with the given level of risk. According to this theory, investors are risk-averse to a given level of return.
Finance v/s Economics
Finance and economics are separate disciplines, but they are interrelated to each other and also converge in some aspects. Finance is all about assessing the money and aspects of financial systems like banks, investments, credit etc. It is all about managing funds while keeping in mind the risk involved. Economics is the study of the scarcity of resources and how to fulfil unlimited wants with these scarce resources. It deals with what to produce, how to produce, and for whom to produce.
The global financial crisis of 2008 affected the functioning of the financial system. It included a sharp decline in the prices of the asset, less volume of credit, and a balance sheet problem. This crisis affected the whole world and created a slowdown in the economies. This crisis was triggered by the collapse of subprime mortgage loans.
In this case, the use of financial economics is large as it helps in analysing the value of the asset and looks after the expected return and risk. It includes quantitative data, which helps to make the best investment decision and overcome any uncertainty. The business environment is quite uncertain, and in the growing globalised world, the use of financial economics is gaining importance.
Financial economics helps to understand the economy on a quantitative basis. It gives a wider perspective for decision-making by analysing the risk involved with an expected return. It talks about the economic condition in monetary terms and helps to value our investments and assets. This aspect of economics considers the financial variables and helps to take the best decision which has less risk and more return.