Financial Economics

Financial economics is a branch of economics that applies to the study of financial markets, such as the forex and stock markets. Moreover, financial economics studies financial instruments, such as bonds, commodities and stocks, and also includes the study of financial institutions and market regulations.

Financial economics studies the relationship among financial variables, such as prices, inflation and interest rates and also focuses on the effect of economic variables, such as GDP (Gross Domestic Product) and CPI (Consumer Price Index), on the financial markets. Its study mainly concentrates on two basic concepts of uncertainty and the time value of money.

Financial economics essentially differs from other branches of economics as its primary focus and concentration is on monetary activities in the market.

Financial economics is a highly quantitative and objective field. It studies the fair value of an asset by evaluating the associated risk factors and cash generated by the asset.

The study of Financial economics revolves mainly around the Portfolio Theory and the Capital Asset Pricing Model.

• Portfolio Theory:    Based on the assuming that the investors are generally unwilling to take risks, the Portfolio Theory focuses on the valuation of securities, allocation of assets, measurement and optimisation of portfolio performance to maximise returns. This theory aims towards minimising the risk in an investment through the diversification of investment capital.
• Capital Asset Pricing Model (CAPM):    This model opines that investors must be compensated for the risks they are undertaking and the time value of money. According to CAPM, the expected return from a security is the sum of the rate on a risk-free security and a risk premium.

Financial economics helps investors make more informed decisions about investment options.