Financial economics

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing (or "investment theory") and corporate finance; the first being the perspective of providers of capital and the second of users of capital.

The subject is concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment". It therefore centers on decision making under uncertainty in the context of the financial markets, and the resultant economic and financial models and principles, and is concerned with deriving testable or policy implications from acceptable assumptions. It is built on the foundations of microeconomics and decision theory.

Financial econometrics is the branch of financial economics that uses econometric techniques to parameterise these relationships. Mathematical finance is related in that it will derive and extend the mathematical or numerical models suggested by financial economics. Note though that the emphasis there is mathematical consistency, as opposed to compatibility with economic theory.

Financial economics is usually taught at the postgraduate level; see Master of Financial Economics. Recently, specialist undergraduate degrees are offered in the discipline.

Note that this article provides an overview and survey of the field: for derivations and more technical discussion, see the specific articles linked.

Underlying economics

JEL classification codes

In the Journal of Economic Literature classification codes, Financial Economics is one of the 19 primary classifications, at JEL: G. It follows Monetary and International Economics and precedes Public Economics. Detailed subclassifications are linked in the following footnote. The New Palgrave Dictionary of Economics (2008, 2nd ed.) also uses the JEL codes to classify its entries in v. 8, Subject Index, including Financial Economics at pp. 863–64. The corresponding footnotes below have links to entry abstracts of The New Palgrave Online for each primary or secondary JEL category (10 or fewer per page, similar to Google searches): JEL: G – Financial Economics JEL: G0 – General JEL: G1 – General Financial Markets JEL: G2 – Financial institutions and Services JEL: G3 – Corporate finance and Governance Tertiary category entries can also be searched.

As above, the discipline essentially explores how rational investors would apply decision theory to the problem of investment. The subject is thus built on the foundations of microeconomics and decision theory, and derives several key results for the application of decision making under uncertainty to the financial markets.

Present value, expectation and utility

Underlying all of financial economics are the concepts of present value and expectation. Calculating their present value allows the decision maker to aggregate the cash flows (or other returns) to be produced by the asset in the future, to a single value at the date in question, and to thus more readily compare two opportunities; this concept is therefore the starting point for financial decision making. Its history is correspondingly early - it was developed in a book on compound interest by Richard Witt ("Arithmetical Questions" (1613)), and these ideas were further developed by Johan de Witt and Edmond Halley. An immediate extension is to then combine probabilities with present value, leading to the expected value criterion which sets asset value as a function of the sizes of the expected payouts and the probabilities of their occurrence. These ideas originate with Blaise Pascal and Pierre de Fermat.

This decision method, however, fails to consider risk aversion ("as any student of finance knows" ). In other words, since individuals receive greater utility from an extra dollar when they are poor and less utility when comparatively rich, the approach is to therefore "adjust" the weight assigned to the various outcomes ("states") correspondingly. (Some investors may in fact be risk seeking as opposed to risk averse, but the same logic would apply). Choice under uncertainty here, may then be characterized as the maximization of expected utility. More formally, the resulting expected utility hypothesis states that, if certain axioms are satisfied, the subjective value associated with a gamble by an individual is that individual's statistical expectation of the valuations of the outcomes of that gamble. The impetus for these ideas arise from various inconsistencies observed under the expected value framework, such as the St. Petersburg paradox (see also Ellsberg paradox). The development here originally due to Daniel Bernoulli, and later formalized by John von Neumann and Oskar Morgenstern.

Arbitrage-free pricing and equilibrium

The concepts of arbitrage-free “Rational” pricing and equilibrium are then coupled with the above to derive "classical" financial economics. Rational pricing is the assumption in financial economics that asset prices (and hence asset pricing models) will reflect the arbitrage-free price of the asset, as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments. Economic equilibrium is, in general, a state where economic forces such as supply and demand are balanced and in the absence of external influences these equilibrium values of economic variables will not change. General equilibrium deals with the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium (this is in contrast to partial equilibrium, which only analyzes single markets.)

The two concepts are linked as follows: Where market prices do not allow for profitable arbitrage, i.e. comprise an arbitrage-free market, so these prices are also said to constitute an "arbitrage equilibrium". Intuitively, this may be seen by considering that where an arbitrage opportunity does exist, then prices can be expected to change, and are, therefore, not in equilibrium. An arbitrage equilibrium is thus a precondition for a general economic equilibrium.

The immediate, and formal, extension of this idea, the Fundamental theorem of asset pricing, shows that under the above conditions we may conduct financial decisioning, applying (or constructing) a risk neutral probability measure; and further, the expected return of any security (or portfolio) equals the riskless return plus an “adjustment for risk,” i.e. a risk premium. All pricing models are then essentially a variant on this, given specific assumptions and / or conditions.

State prices

With the above relationship established, the further specialized Arrow–Debreu model may be derived. This important result suggests that, under certain economic conditions, there must be a set of prices such that aggregate supplies will equal aggregate demands for every commodity in the economy. The analysis here is often undertaken assuming a Representative agent.

The Arrow–Debreu model applies to economies with maximally complete markets, in which there exists a market for every time period and forward prices for every commodity at all time periods. A direct extension, then, is the concept of a state price security (also called an Arrow-Debreu security), a contract that agrees to pay one unit of a numeraire (a currency or a commodity) if a particular state occurs at a particular time in the future and pays zero numeraire in all the other states. The price of this security is the state price of this particular state of the world. Correspondingly, the state price vector is the vector of state prices for all states.

State prices find immediate application in Financial Economics, as will be seen below: for example, any derivatives contract whose settlement value is a function of an underlying whose value is uncertain at contract date can be decomposed as a linear combination of its Arrow-Debreu securities, and thus as a weighted sum of its state prices. Analogously, for a continuous random variable indicating a continuum of possible states, the value is found by integrating over the state price density; see Stochastic discount factor. These concepts are extended to Martingale pricing and the related Risk-neutral measure.

Resultant models

Modigliani–Miller Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and its upward sloped portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the efficient frontier. The graphic displays the CAL, Capital allocation line, formed when the risky asset is a single-asset rather than the market, in which case the line is the CML.

The Capital market line is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio. The CML results from the combination of the market portfolio and the risk-free asset (the point L). Addition of leverage (the point R) creates levered portfolios that are also on the CML.

The capital asset pricing model (CAPM) $E(R_i) = R_f + \beta_{i}(E(R_m) - R_f)$

File:SML-chart.png

Security market line: the representation of the CAPM displaying the expected rate of return of an individual security as a function of its systematic, non-diversifiable risk.

Simulated geometric Brownian motions with parameters from market data.

The Black–Scholes equation $\frac{\partial V}{\partial t} + \frac{1}{2}\sigma^2 S^2 \frac{\partial^2 V}{\partial S^2} + rS\frac{\partial V}{\partial S} - rV = 0$

Binomial Lattice with CRR formulae

Applying the above economic concepts, we may then derive various economic- and financial models and principles. As above, the two usual areas of focus are Asset Pricing and Corporate Finance, the first being the perspective of providers of capital, the second of users of capital. Here, and for (almost) all other financial economics models, the questions addressed are typically framed in terms of "time, uncertainty, options, and information", as will be seen below.

• Time: money now is traded for money in the future.
• Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
• Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
• Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value (FMV).

Applying this framework, with the above concepts, leads to the required models. This derivation begins with the assumption of "no uncertainty" and is then expanded to incorporate the other considerations.

Certainty

A starting point here is “Investment under certainty". The Fisher separation theorem, asserts that the objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. Related is the Modigliani-Miller theorem, which shows that, under certain conditions, the value of a firm is unaffected by how that firm is financed, and depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt. The proof here proceeds using arbitrage arguments, and acts as a benchmark for evaluating the effects of factors outside the model that do affect value.

The mechanism for determining (corporate) value is provided by The Theory of Investment Value (John Burr Williams), which proposes that the value of an asset should be calculated using “evaluation by the rule of present worth”. Thus, for a common stock, the intrinsic, long-term worth is the present value of its future net cash flows, in the form of dividends. What remains to be determined is the appropriate discount rate. Later developments show that, "rationally", i.e. in the formal sense, the appropriate discount rate here will (should) depend on the asset's riskiness relative to the overall market, as opposed to its owners' preferences; see below.

It will be noted that these "certainty" theorems are all commonly employed under corporate finance (see comments under Corporate finance#Quantifying uncertainty and Financial modeling#Accounting); uncertainty is the focus of "asset pricing models", as follows.

Uncertainty

For "choice under uncertainty", the twin assumptions of rationality and market efficiency lead to modern portfolio theory (MPT) with its Capital asset pricing model (CAPM) — an equilibrium-based result — and to the Black–Scholes–Merton theory (BSM; often, simply Black-Scholes) for option pricing — an arbitrage-free result.

Briefly, and intuitively - and consistent with #Arbitrage-free pricing and equilibrium above - the linkage is as follows. If prices of financial assets are (broadly) correct, i.e. efficient, then deviations from these (equilibrium) values could not last for long; correspondingly, prices would be expected to change (only) on the arrival of new information: the random walk hypothesis. Under these conditions investors can then be assumed to act rationally: their investment decision must be calculated or a loss is sure to follow. Also, where an arbitrage opportunity presents itself, then investors will exploit it, reinforcing this equilibrium. Here, as under the certainty-case above, the specific assumption as to pricing is that prices are calculated as the present value of expected future dividends, as based on currently available information. What is required though is a theory for determining the appropriate discount rate given this uncertainty: this is provided by the MPT and its CAPM. Relatedly, rationality — in the sense of arbitrage-exploitation — gives rise to Black-Scholes; option values here ultimately consistent with the CAPM.

In general, then, while portfolio theory studies how investors should balance risk and return when investing in many assets or securities, the CAPM is more focused, describing how — in equilibrium — markets set the prices of assets in relation to how risky they are. The theory demonstrates that if one can construct an efficient frontier (introduced by Harry Markowitz) then mean-variance efficient portfolios can be formed simply as a combination of holdings of the risk-free asset and the "market portfolio" (the Mutual fund separation theorem), with the combinations here plotting as the capital market line, or CML. Then given this CML, the theory shows that the expected return on risky securities will be independent of the investor's utility function, and solely determined by their covariance with aggregate risk (“beta”). As seen in the formula aside, this result is consistent with the preceding, equaling the riskless return plus an adjustment for risk. Note an important implication here: under the assumptions of MPT, an asset may be priced without reference to the investor's level of risk aversion, thus providing a readily determined discount rate for corporate finance decision makers as above.

Black-Scholes provides a mathematical model of a financial market containing derivative instruments, and the resultant formula for the price of European-styled options. The Black–Scholes equation is a partial differential equation describing the price of the option over time. The key financial insight behind the equation is that one can perfectly hedge the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk", absenting the risk adjustment from the pricing. This hedge, in turn, implies that there is only one right price — in an arbitrage-free sense — for the option. Then, assuming log-normal, geometric Brownian motion, we may derive the Black–Scholes option pricing formula, which will return the correct option price. This pricing is without reference to the share's expected return, and hence entails (assumes) risk neutrality; relatedly, therefore, the pricing formula may also be derived directly via risk neutral expectation. See Brownian model of financial markets.

As mentioned, it can be shown that the two models are consistent; then, as is to be expected, "classical" financial economics is thus unified. Here, the Black Scholes equation may alternatively be derived from the CAPM, and the price obtained from the Black-Scholes model is thus consistent with the expected return from the CAPM. The Black-Scholes theory, although built on Arbitrage-free pricing, is therefore consistent with the equilibrium based capital asset pricing. Both models, in turn, are ultimately consistent with the Arrow-Debreu theory, and may be derived via state-pricing, further explaining, and if required demonstrating, this unity.

Extensions

More recent work further generalizes and / or extends these models. Multi-factor models such as the Fama–French three-factor model and the Carhart four-factor model, propose factors other than market return as relevant in pricing. The Intertemporal CAPM, Black–Litterman model, and arbitrage pricing theory similarly extend modern portfolio theory. The single-index model is a more simple asset pricing model than the CAPM. It assumes, only, a correlation between security and market returns, without (numerous) other economic assumptions. It is useful in that it simplifies the estimation of correlation between securities, significantly reducing the inputs for building the correlation matrix required for portfolio optimization. See also: Post-modern portfolio theory; Mathematical finance#Risk and portfolio management: the P world.

As regards derivative pricing, the binomial options pricing model provides a discretized version of Black-Scholes, useful for the valuation of American styled options; discretized models of this type are built using state-prices (as above), while exotic derivatives although modeled in continuous time via Monte Carlo methods for option pricing are also priced using risk neutral expected value. Various other numeric techniques have also been developed. The theoretical framework too has been extended such that martingale pricing is now the standard approach. Since the work of Breeden and Litzenberger in 1978, a large number of researchers have used options to extract Arrow–Debreu prices for a variety of applications in financial economics. Developments relating to complexities in return and / or volatility are discussed below; see also Mathematical finance#Derivatives pricing: the Q world.

Derivative models for various other underlyings and applications have also been developed, all departing from the same logic. Beginning with Oldrich Vasicek, various short rate models, as well as the HJM and BGM forward rate-based techniques, allow for an extension to fixed income- and interest rate derivatives. (The Vasicek and CIR models are equilibrium-based, while Ho–Lee and subsequent models are based on arbitrage-free pricing.) Real options valuation allows that option holders can influence the option's underlying; models for employee stock option valuation explicitly assume non-rationality on the part of option holders; Credit derivatives allow that payment obligations / delivery requirements might not be honored. Exotic derivatives are now routinely valued.

Note that Real Options theory is also an extension of corporate finance theory: asset-valuation and decisioning here no longer need assume "certainty". Relatedly, as discussed above, Monte Carlo methods in finance, introduced by David B. Hertz in 1964, allow financial analysts to construct "stochastic" or probabilistic corporate finance models, as opposed to the traditional static and deterministic models; see Corporate finance#Quantifying uncertainty. Other extensions here include agency theory, which analyses the difficulties in motivating corporate management (the "agent") to act in the best interests of shareholders (the "principal"), rather than in their own interests. Clean surplus accounting and the related residual income valuation provide a model that returns price as a function of earnings, expected returns, and change in book value, as opposed to dividends. This approach, to some extent, arises due to the implicit contradiction of seeing value as a function of dividends, while also holding that dividend policy cannot influence value per Modigliani and Miller’s “Irrelevance principle”; see Dividend policy#Irrelevance of dividend policy.

Challenges and criticism

Market anomalies and Economic puzzles

Calendar effect January effect Santa Claus rally Sell in May Closed-end fund puzzle Dividend puzzle Equity home bias puzzle Equity premium puzzle Forward premium anomaly Low-volatility anomaly Post-earnings-announcement drift Real exchange-rate puzzles

Implied volatility surface. The Z-axis represents implied volatility in percent, and X and Y axes represent the option delta, and the days to maturity.

See also: Capital asset pricing model#Problems of CAPM; Modern portfolio theory#Criticisms; Black–Scholes model#Criticism; Financial mathematics#Criticism; List of unsolved problems in economics#Financial economics;.

As seen, a common assumption is that financial decision makers act rationally; see Homo economicus. However, recently, researchers in experimental economics and experimental finance have challenged this assumption empirically. These assumptions are also challenged theoretically, by behavioral finance, a discipline primarily concerned with the limits to rationality of economic agents.

Consistent with, and complementary to these findings, various persistent market anomalies have been documented, these being price and/or return distortions - e.g. size premiums - which appear to contradict the efficient-market hypothesis; calendar effects are the best known group here. Related to these are various of the economic puzzles, concerning phenomena similarly contradicting the theory. The equity premium puzzle, as one example, arises in that the difference between the observed returns on stocks as compared to government bonds is consistently higher than the risk premium rational equity investors should demand, an "abnormal return". For further context see Random walk hypothesis#A non-random walk hypothesis, and sidebar for specific instances.

Areas of research attempting to explain (or at least model) these phenomena include noise trading, market microstructure, and Heterogeneous agent models. The latter is extended to agent-based computational economics, where price is treated as an emergent phenomenon, resulting from the interaction of the various market participants (agents). The noisy market hypothesis argues that prices can be influenced by speculators and momentum traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to fundamental value; see Noise (economic). The adaptive market hypothesis is an attempt to reconcile the efficient market hypothesis with behavioral economics, by applying the principles of evolution to financial interactions. An information cascade, alternatively, shows market participants engaging in the same acts as others ("herd behavior"), despite contradictions with their private information. See also George Soros' approach: #Reflexivity, financial markets, and economic theory.

On the obverse, various studies have shown that despite these departures from efficiency, asset prices do typically exhibit a random walk and that one cannot therefore consistently outperform market averages. The practical implication, therefore, is that passive investing (e.g. via low-cost index funds) should, on average, serve better than any other active strategy. Burton Malkiel's A Random Walk Down Wall Street - first published in 1973, and in its 12th edition as of 2015 - is a widely read popularization of these arguments. Note also that institutionally inherent limits to arbitrage — as opposed to factors directly contradictory to the theory — are sometimes proposed as an explanation for these departures from efficiency.

As above, the assumptions that market prices follow a random walk and / or that asset returns are normally distributed are fundamental. Empirical evidence, however, suggests that these assumptions may not hold (see Kurtosis risk, Skewness risk, Long tail) and that in practice, traders, analysts and particularly risk managers frequently modify the "standard models" (see Model risk). In fact, Benoît Mandelbrot had discovered already in the 1960s that changes in financial prices do not follow a Gaussian distribution, the basis for much option pricing theory, although this observation was slow to find its way into mainstream financial economics. Financial models with long-tailed distributions and volatility clustering have been introduced to overcome problems with the realism of classical financial models; jump diffusion models allow for (option) pricing incorporating "jumps" in the spot price. Risk managers, similarly, complement (or substitute) the standard value at risk models with historical simulations, mixture models, principal component analysis, extreme value theory, as well as models for volatility clustering. For further discussion see Fat-tailed distribution#Applications in economics.

Closely related is the volatility smile, where implied volatility is observed to differ as a function of strike price (i.e. moneyness). The term structure of volatility describes how (implied) volatility differs for related options with different maturities; an implied volatility surface is a three-dimensional surface plot of volatility smile and term structure. These empirical phenomena negate the assumption of constant volatility — and log-normality— upon which Black-Scholes is built. See Black–Scholes model#The volatility smile. Approaches developed here in response include local volatility and stochastic volatility (the Heston, SABR and CEV models, amongst others). Alternatively, implied-binomial and -trinomial trees instead of directly modelling volatility, return a lattice consistent with — in an arbitrage-free sense — (all) observed prices, facilitating the pricing of other, i.e. non-quoted, strike/maturity combinations. Edgeworth binomial trees allow for a specified (i.e. non-Gaussian) skew and kurtosis in the spot price. Priced here, options with differing strikes will return differing implied volatilities, and the tree can thus be calibrated to the smile if required. Similarly purposed closed-form models include: Jarrow and Rudd (1982); Corrado and Su (1996); Backus, Foresi, and Wu (2004).

Particularly following the financial crisis of 2007–2010, financial economics and mathematical finance have been subjected to criticism; notable here is Nassim Nicholas Taleb, who claims that the prices of financial assets cannot be characterized by the simple models currently in use, rendering much of current practice at best irrelevant, and, at worst, dangerously misleading; see Black swan theory, Taleb distribution. A topic of general interest studied in recent years has thus been financial crises, and the failure of financial economics to model these. See also Financial Modelers' Manifesto; Physics envy; Unreasonable ineffectiveness of mathematics#Economics and finance.

See also

• Category:Finance theories
• Category:Financial economists
• Deutsche Bank Prize in Financial Economics
• Financial modeling
• Fischer Black Prize
• List of unsolved problems in economics#Financial economics
• Outline of economics
• Outline of finance

Bibliography

Financial economics

Asset pricing

Corporate finance

External links

Theory

• The History of Finance: An Eyewitness Account. Merton H. Miller
• Great Moments in Financial Economics I, II, III, IVa, IVb (archived, 2007-06-27). Prof. Mark Rubinstein, Haas School of Business
• The Scientific Evolution of Finance (archived, 2003-04-03). Prof. Don Chance, Louisiana State University, Prof. Pamela Peterson James Madison University
• The Theory of Corporate Finance: A Historical Overview, Michael C. Jensen and Clifford W. Smith.
• Microfoundations of Financial Economics Prof. André Farber, Solvay Business School
• An introduction to investment theory, Prof. William Goetzmann, Yale School of Management
• Macro-Investment Analysis. Prof. William F. Sharpe, Stanford Graduate School of Business
• Finance Theory (MIT OpenCourseWare). Prof. Andrew Lo, MIT.
• Financial Theory (Open Yale Courses). Prof. John Geanakoplos, Yale University.
• The Theory of Investment at the Wayback Machine (archived June 21, 2012). Prof. G.L. Fonseca, New School for Social Research
• An Overview of Modern Financial Economics. Chi-fu Huang, MIT Working paper
• Introduction to Financial Economics. Gordan Zitkovi, University of Texas at Austin
• An Introduction to Asset Pricing Theory, Junhui Qian, Shanghai Jiao Tong University
• What We Do Know: The Seven Most Important Ideas in Finance; What We Do Not Know: 10 Unsolved Problems in Finance, Richard A. Brealey, Stewart Myers and Franklin Allen.

Links and portals

• Financial Economics Links on WebEc
• JEL Classification Codes Guide
• Financial Economics Links on RFE
• SSRN Financial Economics Network
• Financial Economics listings on economicsnetwork.ac.uk
• Financial Economics Resources on QFINANCE

Actuarial resources

• Models for Financial Economics (MFE), Society of Actuaries
• Financial Economics (CT8), Institute and Faculty of Actuaries
• A Primer In Financial Economics, S.F. Whelan, D.C. Bowie and A.J. Hibbert. British Actuarial Journal, Volume 8, Issue 01, April 2002, pp 27–65.
• Pension Actuary's Guide to Financial Economics. Gordon Enderle, Jeremy Gold, Gordon Latter and Michael Peskin. Society of Actuaries and American Academy of Actuaries.