how financial economics works
making financial decisions is not always a straightforward process time risk opportunity costs and information can create incentives and disincentives financial economics employs economic theory to evaluate how certain things impact decision making providing investors with the instruments to make the right calls financial economics usually involves the creation of sophisticated models to test the variables affecting a particular decision often these models assume that individuals or institutions making decisions act rationally though this is not necessarily the case the irrational behavior of parties has to be taken into account in financial economics as a potential risk factor this branch of economics builds heavily on microeconomics and basic accounting concepts it is a quantitative discipline that uses econometrics as well as other mathematical tools financial economics necessitates familiarity with basic probability and statistics since these are the standard tools used to measure and evaluate risk financial economics studies fair value risk and returns and the financing of securities and assets numerous monetary factors are taken into account including interest rates and inflation financial economics vs traditional economicstraditional economics focuses on exchanges in which money is one but only one of the items traded in contrast financial economics concentrates on exchanges in which money of one type or another is likely to appear on both sides of a trade the financial economist can be distinguished from traditional economists by their focus on monetary activities in which time uncertainty options and information play roles financial economics methodsthere are many angles to the concept of financial economics two of the most prominent are decision making over time recognizes the fact that the value of 1 in 10 years time is less than the value of 1 now therefore the 1 at 10 years must be discounted to allow for risk inflation and the simple fact that it is in the future failure to discount appropriately can lead to problems such as underfunded pension schemes advertisements for stock market based financial products must remind potential buyers that the value of investments may fall as well as rise financial institutions are always looking for ways of insuring or hedging this risk it is sometimes possible to hold two highly risky assets but for the overall risk to be low if share a only performs badly when share b performs well and vice versa then the two shares perform a perfect hedge an important part of finance is working out the total risk of a portfolio of risky assets since the total risk may be less than the risk of the individual components 