What’s it: Financial economics is one of the branches of economics that focuses on money. It is the intersection between financial studies, financial markets, and economics. In other words, this study pays greater attention to the monetary side of an economy.
Basic knowledge you need to study financial economics is::
- Basic probability and statistics
For the latter, it is essential to measure and evaluate the rate of return and risk.
This study field is essential to you because it provides a knowledge base for making decisions about the money. You will learn a lot about:
- Options to allocate money.
- Calculating the return and risk of the money allocation
- Risk factors attached to each allocation
- The fair value of the assets you wish to collect
The difference between financial economics and economics
In economics, goods and services become objects of transactions. I mean, supply and demand are for goods and services. Money only acts as a means of payment and only appears from one party when the other party delivers goods or provides services.
But, in the study of financial economics, money is the object of supply and demand. Meanwhile, interest represents the price of money. Furthermore, you may often come across broader terms than money, such as capital, cash, funds, and finance capital.
The money supply does not only come from the business sector, but also from the household sector (individuals) and the government sector. For suppliers of funds, interest is the return when they lend money. The term money suppliers can take various terms, such as an investor, bondholder, shareholder, lender, and creditor.
Furthermore, the demand for money also originates from these three sectors (individuals, businesses, and government). Individuals borrow for several expenses, such as buying a house and paying for education. Companies borrow to purchase capital equipment or as working capital. The government borrows money to cover the budget deficit.
Financial economics topics
Financial economics concentrates on making decisions based on two primary considerations: risk and return. The subject is usually applied to investment decisions, especially in financial markets such as the stock market, foreign exchange market, and debt securities market. It is becoming an increasingly important discipline, considering the growing contribution of financial markets to the economy.
In this field of study, you learn about making investment decisions, identifying risks, and valuing securities and other financial assets. You will also understand how economic indicators, such as inflation and interest rates, impact financial assets.
Analysis of an asset’s fair value and the amount of cash that can be made from an investment is another chapter of financial economics study.
Time value of money
Value of money changes over time. The $60 you hold in 2020 won’t give you the same buying power in 2030. If you can get a sneaker now for $60, then in 2030, you probably won’t get it with the same amount of money.
Risks such as inflation can erode your purchasing power. Therefore, to calculate your $ 60 bill’s purchasing power in 2030, you must calculate its future value. In this case, you can figure it using compound interest.
Now, the question is back. What is the present value of your $60 bills in 2030? You can use the discount rate to calculate it.
Basically, compound interest and discount rates are the interest rates attached to your money. To convert the future value of money (cash) to present value, we call it the discount rate. Conversely, if you convert present value to future value, we call it compound interest.
As I said before, interest is the price of money. And, the interest rate is determined by:
- The minimum return you are likely to get (risk-free). Another term for this is the real interest rate.
- Risk premium. It is an extra return to compensate for additional risks such as inflation, liquidity risk, default risk, and maturity risk.
Risk and return are inherent in every financial asset. For example, you can see stock returns are sometimes high and sometimes low. Likewise, with bonds, the price sometimes goes up and sometimes goes down.
To optimize returns and minimize risk, theorists raise a portfolio management concept. Broadly speaking, it tells you how to diversify and allocate your money to various financial assets.
Modern portfolio theory argues that the characteristics of risk and return on investment should not be seen individually. Still, you must evaluate it in the context of the portfolio as a whole. This theory suggests that you can build a portfolio of multiple assets to maximize returns for a certain risk level. Likewise, with the expected return rate, you can build a portfolio with the lowest possible risk.
Capital Asset Pricing Model (CAPM)
Capital Pricing Asset Pricing Model (CAPM) is a model for evaluating the risk and return of risky assets. It is useful for determining benchmarks and for assessing the return rate on an asset’s investment.
The formula is as follows:
Rs = Rfr + (Beta x (Rm– Rfr)
- Rs = Expected return for an asset
- Rfr = Risk-free rate
- Beta = Beta of the asset
- Rm = Expected market return.
Let’s take a simple example. Say, a ten-year government bond represents a risk-free asset and gives a yield of about 6%. A stock of company A has a beta of about 0.5. Meanwhile, the stock market rate of return is around 12%.
By plugging this information into the formula, we know that the expected return on company A’s stock is 9% [6% + 0.5 x (12% -6%)].