Financial Economics

What Is Financial Economics?

Financial economics is the branch of economics that study the use of resources in the financial markets. It focuses on financial markets, investments, corporate finance, and other financial and monetary activities. It involves studying how people allocate scarce resources over time under conditions of uncertainty. 

It analyzes the utilization of resources and funds in the open market, considering future risks, opportunity costs, volatility in stock prices, etc. It concentrates on the forex and stock markets taking into consideration various financial variables that impact the economy, such as inflation, deflation, recession, depression, stock market, uncertainty, and future risks. 

• Financial economics definition refers to the economics that evaluates the allocation of funds in different investment avenues.
• It helps determine the risk and return by keeping track of events such as changes in stock prices, fluctuations in the economic cycles, inflation, etc.
• Financial economics involves studying the financial system where investment activities or the conversion of savings to investment happens. 
• This area of economics relies on microeconomics, basic accounting principles, economic theories, mathematics, and statistics. 

Financial Economics Explained

Financial economics involves studying the financial system where investment activities or the conversion of savings to investments happens. This area of economics relies on microeconomics, basic accounting principles, economic theories, mathematics, and statistics. It also points to the importance of mathematics in financial economics. The importance of its understanding and application is that it helps in hedging the risk in the future by analyzing the future markets, thus helping investors before they invest in diversified portfolios and securities.

It is concerned with determining the fair value of an asset and cash inflows generated from an asset. This branch also encompasses investment decisions regarding bonds, stocks, and securities. In addition, it evaluates market regulations that govern the markets of stocks, bonds, and other diversified investment options. 

The Journal of Financial Economics is an academic publication addressing theoretical and empirical financial and economic topics. It includes emphasis on the contributions in capital markets, entrepreneurial finance, corporate finance, corporate governance, macro-finance, behavioral finance, and household finance. Furthermore, financial economics books like "Principles of Financial Economics" also explain financial economics. 

The financial economist helps in managing investment-related risks. Almost all financial transactions involve some level of risk. For example, the stock market is subjected to price volatility, where market trends can change at every point. Investing in stocks, bonds, and various other securities can produce enormous profits, but it is also subjected to market risk. Generally, it is assumed if an investor holds various risky assets, the performance of one should compensate for the performance of the other. Therefore, risk hedging is necessary before investing in any asset. In other words, portfolios must be well managed and diverse to reduce risk.

Examples

Let us look at the financial economics example to understand the concept better:

Example #1

A person's wealth may be significantly impacted if they make an extravagant purchase, such as paying for a property that exceeds their normal budget and requires additional financing. To pay for the expense, the person can take out a home loan, use all available credit on credit cards, utilize fixed deposits, and there is the option to withdraw money from retirement savings, mutual funds, or stocks. In this case, financial economics can determine the sourcing and allocation of the fund. It helps in minimizing the risk in the future and allocate the funds wisely in the present scenario.

Example #2

The financial economics of gold is another illustration. In many nations, gold is one of the favored forms of investment. According to the article "The Financial Economics of Gold — A Survey" by Fergal A.O. Connor, Brian M.Lucey, Jonathan A. Batten, and Dirk G. Baure, examining how the gold markets function entails looking at the underexplored leasing market, research on physical gold demand and supply, gold mine economics, gold market efficiency, the possibility of gold market bubbles, the relationship between gold and inflation and interest rates, and behavioral factors influencing gold investment decisions.

Example #3

Another example is portrayed by the relationship between social mood and financial economics, and it is based on the article by John R. Nofsinger. The article explains that the emotions of those who make financial decisions mirror society's general degree of optimism or pessimism. The article explains three significant implications due to the correlation between these feelings and economic involvement.

First, customers, investors, and corporate managers make decisions based on the current social mood. Optimistic (pessimistic) collective investment and corporate activity are indicators of social mood extremes. Second, the stock market is a direct indicator or barometer of societal mood due to the compelling and sensitive character of stock transactions. Third, stock market patterns aid in forecasting future financial and economic activity since the nature of corporate activity follows social mood.

Financial Economics vs Economics

In economics, supply and demand play a crucial part in goods and services transactions, and money is the medium of exchange when goods and services are delivered from one party. In financial economics, money is an important element on both sides of the trade. Money is allocated in different sorts of assets, thus pointing to the importance of financial decisions by looking into various aspects such as time, return, risk, economic indicators, etc. 

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to What is Financial Economics and its definition. Here, we explain it with examples and compare it with economics. You can learn more about it from the following articles -

• Keynesian Economics
• Managerial Economics
• Business Economics