Financial Economics

If you have ever wondered why stock markets go up or down or what terms such as ‘portfolio management’ or ‘hedge fund’ mean then you need to study financial economics. As a bonus, it prepares you for any job in financial services and would help you understand the principles behind many important personal financial decisions that you will have to make (taking out a mortgage, saving for a pension, buying insurance).

Dr. Edmund Cannon, University of Bristol

Financial economics concentrates on decision making when two considerations are particularly important: first, some of the outcomes are risky; second, both the decisions and the outcomes may occur at different times. The subject is usually applied to investment decisions, particularly in financial markets (hence the name) such as the stock market, but it also has close links to the parts of microeconomics connected with insurance and saving.

Image by Bhagesh Sachania

Financial economics has many aspects. Two of the most important are:

Discounting: Decision making over time recognises the fact that the value of £1 in ten years’ time is less than the value of £1 now. The £1 ten years’ hence must be discounted to allow for risk, inflation and the simple fact that it is in the future. Failure to discount appropriately has led to problems such as the systematic underfunding of pension schemes that we have seen in recent years.

Risk management and diversification: Many advertisements for financial products based on the stock market remind potential buyers that the value of investments may fall as well as rise. So although stocks yield a return which is high on average, this is largely to compensate for risk. 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.

Financial economics builds heavily on microeconomics and basic accounting concepts. In addition, it requires familiarity with basic probability and statistics, since these are the standard tools used to measure and evaluate risk.

Web Links

VoxEU’s section on Financial Markets

VoxEU’s section on International Finance