What is the financial economy?
Financial economics is a branch of the economy that analyzes the use and distribution of resources in markets where decisions are made with uncertainty. Financial decisions often have to take into account future events, whether related to individual stocks, portfolios or the market as a whole.
Key points to remember
- Financial economics analyzes the use and distribution of resources in markets where decisions are made with uncertainty.
- It uses economic theory to assess how time, risk (uncertainty), opportunity costs and information can create incentives or disincentives for a particular decision.
- Financial economics often involves the creation of sophisticated models to test the variables affecting a particular decision.
How the financial economy works
Making financial decisions is not always a simple process. Time, risk (uncertainty), opportunity costs and information can create incentives or disincentives. Financial economics uses economic theory to assess how certain things affect decision-making, providing investors with the tools to make the right choices.
Financial economics often involves the creation of sophisticated models to test the variables affecting a particular decision. Often, these models assume that individuals or institutions that make decisions act rationally, although this is not necessarily the case. The irrational behavior of the parties must be taken into account in financial economics as a potential risk factor.
This branch of the economy relies heavily on microeconomics and basic accounting concepts. It is a quantitative discipline that uses econometrics and other mathematical tools. This requires knowledge of probability and basic statistics, as these are the standard tools used to measure and assess risk.
Financial economics studies fair value, risks and returns, and the financing of securities and assets. Many monetary factors are taken into account, including interest rates and inflation.
Financial economy vs. Traditional economy
The traditional economy focuses on exchanges in which money is one – but only one – of the items exchanged. In contrast, the financial economy focuses on exchanges in which currency of one type or another is likely to appear on both sides of a trade.
The financial economist is distinguished from more traditional economists by their concentration on the monetary activities in which time, uncertainty, options and / or information play a role.
Financial saving methods
The concept of financial economy has several angles. Two of the most important are:
Decision-making over time recognizes that the value of $ 1 in 10 years is less than the value of $ 1 today. Therefore, the 10-year dollar must be updated to take into account risk, inflation and the simple fact that it will be in the future. Failure to properly update can lead to problems, such as underfunded pension plans.
Risk management and diversification
Many advertisements for financial products based on the stock market should remind potential buyers that the value of investments can go up as well as down, so that while stocks generate high returns on average, this is largely for offset the risk.
Financial institutions are always looking for ways to insure or hedge this risk. It is sometimes possible to hold two very risky assets but for the overall risk to be low: if the action A does not behave badly only when the action B is doing well (and vice versa) then the two actions achieve perfect hedging. An important part of financing is to determine the total risk of a portfolio of risky assets, since the total risk may be lower than the risk of the individual components.