What is financial economics definition & its main methods of analysis?

Financial economics

Financial Economics is a field of study where finance and economics are combined to help the investors in making informed decisions regarding investments. However, this is essentially a branch of economics.

This branch of economics is mostly concerned with monetary activities and investment decisions. 

Financial economics analyses the use and distribution of resources in the market. The term market indicates financial markets here. The concepts and tools used in finance and economics are used to find the most lucrative investment options. 

What is financial economics definition & its main methods of analysis

What role does financial economics play?

The underlying theory that rules the field of financial economics is that no rational investor shall invest to lose money. The rational investor is guided by the idea of getting a higher return but also undertaking a lower risk. But higher return assets are usually of high risk. So how to come to a middle ground? This is where financial economics comes to the rescue. The best investment options are selected based on the two parameters– high return and low risk. This field of study is based on decision-making theory and microeconomics.

What do financial economists do?

Financial economists take into consideration financial variables like share prices, interest rates, inflation, and exchange rates while analyzing financial assets. They also come up with sophisticated models to see how these financial variables would behave in a given situation. The models are built on assumptions. Economics concepts that are studied in classrooms are also based on certain assumptions. Otherwise, it would be very difficult to analyze.

Parameters like time, risk, and opportunity costs are also considered while analyzing the investment options.

Financial economics has two main methods of analysis

Discounting

Financial economics is future-oriented. It checks how profitable an asset will be in the future considering the financial variables stated above. Discounting means we are converting the present value into the future value so that an accurate comparison can be done. Discounting is done using the concept of ‘time value of money and inflation. What Rs. 1 lac can buy today will not be the same 10 years down the line. The same 1 lac will not be able to buy the same number of commodities in the future, as it can today. The reason being the prices of goods rise over time due to inflation. This is the concept of discounting.

Risk management

Financial economists are assigned to manage the risk associated with investment portfolios. They always intend to hedge or minimize the risk for their clients. The portfolio is always diversified in a way that the investments will be inversely related especially in high-risk assets. This means that the failure of one high-risk asset will mean the success of the other high-risk asset. Thus, the overall risk of the portfolio decreases. This is known as hedging or risk minimization.

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