Financial economics

Financial economics treats the financial system as an open interactive system dealing both in claims upon future goods and services, and in the allocation of the risks that are associated with such claims. It is concerned with the investment choices made by individuals, with the financing choices made by corporations, with the conduct of financial organisations that act as financial intermediaries between individuals and corporations; and with the effects of it all upon the economy.

(See the related articles subpage for definitions of the terms shown in italics in this article)

Financial systems

Common features

The essential functions of a financial system are taken to be to connect prospective investors with investment opportunities, and to allocate risk in accordance with the preferences of prospective risk-takers. Its components are taken be corporations, investors, financial intermediaries and a financial regulator; its instruments are taken to include a variety of types of shareholding, debt instruments and options that are traded, together with financial derivatives, in a variety of financial markets; and its activities are taken to be governed by rules and practices administered by regulatory authorities.

The financial activities of governments are the subject of a separate article on public finance, and investment choices within corporations are the subject of a separate article on business economics.

Effects on economic performance

The evidence strongly suggests that a well-developed financial system is good for economic growth, and although comparisons between systems in which companies raise finance mainly by borrowing from the banks (as in Germany and Japan) with "equity-based systems" in which companies raise it mainly by issuing shares (as in the United States and Britain) have been inconclusive, they suggest that equity-based systems are better at promoting hi-tech growth. Equity-based systems promote economic activity by enabling prospective investors to finance capital investment by purchasing shares offered by corporations. The incentive to do so is increased by a facility to dispose of them at will in financial markets, and that incentive is further increased by the availability of financial derivatives that help the prospective investor to chose his preferred combination of risk and return.

The effect of the financial system upon economic stability is discussed in the concluding paragraph of this article.

The choices facing investors

The efficient market hypothesis

Long before economic analysis was applied to the problem, investment analysts had been advising their clients about their stock market investments, and fund managers had been taking decisions on their behalf. Some sought to predict future movements of the price of a share from a study of the pattern of its recent price movements (known as “technical analysis”) and some attempted to do so by examining the issuing company’s competitive position and the factors affecting the markets in which it operates (known as "fundamental analysis"). But in 1933, an economist suggested that both might be wasting their time. Applying the concept of a "perfect market" to the stock exchange, the economist Alfred Cowles asked the question "Can Stock Market Forecasters Forecast?" and gave his answer as "it is doubtful", thereby starting a controversy that has yet to be fully resolved. Cowles argued that in an "efficient market" all of the information upon which a forecast could be based was already embodied in the price of the share in question, subject only to unpredictable fluctuations having the characteristics known to statisticians as a random walk.

The question whether stock markets do in fact operate as efficient markets was subsequently explored in studies undertaken and summarised by the economist Eugene Fama and others. Fama concluded that there is no important evidence to suggest that prices do not adjust to publicly available information, and only limited evidence of privileged access to information about prices. It appears that, although some investment analysts may acquire some useful information, most of them do not. A 1967 study of the average performance of managers of mutual funds indicated that they had not been successful enough to pay their brokers’ fees , and subsequent studies have reached similar conclusions. The paradoxical consequence of market efficiency would seem to be that the more effective are the efforts of the experts to make best use of the relevant information, the less likely they are to benefit from those efforts.

Risk limitation

The value of any investment is definitionally equal to the present value of its future cash flows when discounted at the investor’s discount rate - an identity that is known as the dividend discount model. It is a method that is of limited usefulness in valuing shares because of the uncertainties surrounding the future of the issuing company. It is conceptually possible to allow for those uncertainties by applying subjective probability weightings to each of what are conceived to be the possible outcomes, in order to produce an estimate of the investment’s net present expected value (see the article on net present value). If such a calculation were feasible, a rational choice would be to buy if the net present expected value (net, that is to say, of the purchase price) is greater than zero – or, even better, to buy the asset that has the largest positive net present value of all the assets that are on offer. But it would not be rational to devote all of one’s savings to that asset, even if the probable outcome had been correctly estimated. Every investor needs to limit the risk of total loss; and investors differ in their attitudes to less important risks.

The well-known way of limiting such risks is to buy a diversified share portfolio – a strategy that was analysed in detail in the 1950s by the economist Harry Markowitz . Markowitz reasoned that what matters is the riskiness of the portfolio rather than its components, and that the riskiness of the portfolio depended, not so much upon the riskiness of its components, as upon their covariance, meaning the tendency of their prices rise and fall in concert. He went on to develop what has come to be known as Modern Portfolio Theory concerning the problem of adjusting a portfolio mix to give the maximum return for a given level of risk. Complex procedures are involved in which assets are grouped according to their riskiness and their covariance. The risk of holding an equity came to be categorised as consisting of "unsystematic risk", which can be reduced by diversification, and "systematic risk" which results from the rise and fall of the equity market as a whole. Modern portfolio theory now takes account of an extension of the Markowitz analysis to include cash, and the possibility of borrowing in order to invest, that was developed by James Tobin . Tobin demonstrated that the process of finding an optimum portfolio for a given level of risk involves two separate two decisions: first finding an optimal mix of equities, and then combining it with the amount of cash necessary to meet the risk requirement - a result known as "Tobin's Separation Theorem". He also argued that in a perfect market with only rational investors, the optimal mix of equities would consist of the entire market.

Equity pricing

The value of an asset is determined by its expected rate of return which, in turn, is related to its riskiness. Competition may be expected to ensure that equities earn greater returns than government bonds in order to compensate their purchasers for undertaking greater risks. The difference for any given share is termed its risk premium. A theorem developed by the economist William Sharpe proves that, under certain ideal circumstances, a share's risk premium will be equal to the equity market’s risk premium multiplied by a factor that he termed "Beta", which is related to the covariance of that share's rates of return with the corresponding rates for the equity market as a whole. The result is known as the Capital Asset Pricing Model (CAPM) . Sharpe's proof depends upon the assumption that all investors effectively free themselves of "unsystematic" risk by diversification and receive a risk premium only for the remaining "systematic risk" (he argued that rational investors in a perfect market would arbitrage away any premium gained in return for avoidable risks). Subsequent investigators have tried to establish whether, despite those somewhat unrealistic assumptions, the stock market behaves as predicted by the model. A 1972 study of the New York Stock Exchange during the period 1931-65 broadly confirmed the existence of proportionality between the prices of shares and their Betas , a 1992 study of the New York, American and NASDAQ stock exchanges during the period 1963-90 did not indicate any such proportionality , and the findings of a 1993 paper using a different methodology tended to confirm the CAPM prediction . The controversy continues, but many economists believe that Beta is a significant factor, although not the only factor, that influences share prices.

The possibility that other factors exert a significant influence is allowed for in an extension of the CAPM methodology, termed the "Arbitrage Pricing Theory" (APT) . The theory leaves it to its users to identify the factors likely to influence the price of a share and to weight them according to their relative importance. Firm size, price, earnings ratio, and dividend yield have been found to be relevant factors, as well as factors that are relevant to the markets in which the firm operates . In the 1970s, however, two American economists came to realise that the future volatility of the price of an asset is already allowed for in the operation of the options market, and that it should be possible to deduce the market's expectation of its volatility from the prices ruling in that market. Fischer Black and Myron Scholes developed what came to be known as the "Black-Scholes Model and published their results in a 1973 paper ; an achievement that eventualy resulted in the award of the Nobel prize for economics . The model can be used either to determine the fair price for an option on an asset from an estimate of its price volatility, or to estimate the market's expectation of the asset's price volatility from the price of an option for it. (The mathematical form of the theorem, and some of the assumptions on which it depends are set out on the tutorials subpage). The Black-Scholes theorem was used by Robert Merton as the basis for a technique known as "Contingent Claims Analysis" that can be applied to the pricing of almost any form of financial asset .

The financing choices facing corporations

The financing choices open to companies are determined by the choices open to investors - and that is true of choices concerning the issue of shares or bonds. A company's shareholders become its true owners only after all its debts have been repaid. In principle, therefore, their view of a company's debts should depend upon the opportunity they have to repay them. If they could do so costlessly, using money borrowed at the same rate as that paid by the company, then shareholders should be indifferent to the existence of debt. It should not matter to them whether they have shares in a company with no debt, or in a similar company with debt that could be costlessly repaid. That was the insight into the economics of company finance that was put forward by Modigliani and Miller in 1958. . On those assumptions the view of a company taken by the finance market would be unaffected, even by unlimited levels of gearing. Reality differs in several respects. Gearing increases the risk that the company's income might fall to a level at which it could not make its contractual income payments - at which point it would become insolvent. On the other hand, it usually gives the company a tax advantage because most tax systems treat interest payments as an expense that can be deducted from income before calculating tax liability. According to the "trade-off theory" of corporate finance, the appropriate decision- making procedure under those circumstances is to increase gearing to the point at which the tax advantage offsets the risk-adjusted cost of insolvency. . The rival "pecking order" theory suggests that companies prefer the cheapest available form of finance, choosing retained profits, debt and equity in that order of preference. Most of the empirical evidence appears to favour the trade-off theory. Much of the evidence also suggests that high gearing can have a negative effect upon corporate growth, but the exceptions in both cases suggest that there are other factors that have to be taken into account. Among possible additional factors are the possibilities of agency costs arising from conflicts of interest between shareholders and managers and assymmetry of information between shareholders and managers , but it has been suggested that the threat of a hostile takeover, leading to replacement of an existing management, may mitigate such costs .

The problems facing the financial intermediaries

(For more detailed information about the operation of the financial intermediaries, see the article on the financial system.)

The problems facing the financial intermediaries arise mainly from the fact that they make up a tightly-coupled complex interactive system, in which an error of judgement in one of its members can have repercussions in many of the others. The investment banks, which are its largest element, are particularly sensitive to such errors because they borrow and lend vastly greater sums of money than they themselves possess. A mistake that involves a minor proportion of a bank's turnover could consequently have a devastating effect upon its own finances. That sensitivity to relatively minor errors also characterises financial institutions that operate at very high level of gearing, because of their dependence upon sufficient earnings to meet their interest-paying obligations. Those problems have been tackled by the widespread use of risk analysis. Schemes of "portfolio insurance" using options priced in accordance with the Black-Scholes model) became popular in the 1980s, and they have been followed since then by a variety of tailor-made risk-management products. Widespread use was made of a variety of "value at risk" calculations (which apply standard probability distributions to the observed volatility of market prices) . The increased competition that then developed between financial intermediaries led to reduced profit margins on individual transactions, so that profitable trading came to require a large number transactions, and increased gearing became necessary to finance them. Thousands of highly professionally-managed computer-operated "hedge funds" came in existence in the 1990s, some using borrowed money amounting to over twenty times their own capital.

The roles of financial regulators

In England, the need for regulation of the financial intermediaries became evident in 1866 when the collapse of the Gurney-Overend bank caused a panic in which large numbers of people tried to withdraw deposits from their banks; leading to the collapse of over 200 companies . On that occasion the Bank of England had refused to help, but the influential commentator Walter Bagehot urged that in a future panic it should "advance freely and vigorously to the public out of its reserves" in order to avoid another "run on the banks", and in 1890 the Bank rescued the failing Barings bank by guaranteeing loans to it by other banks . In the United States there was similar initial inaction in face of the much more serious panic of 1893 but following the further panic of 1907 the Congress created the Federal Reserve System and granted it powers to assist banks that faced demands that they would otherwise be unable to meet. There was controversy among economists concerning the justification for such intervention. Monetarists such as Anna Schwartz argued that it should only be used to deal with a banking panic, such as would that would otherwise cause a substantial fall in the money supply . Others argued that it should be used to deal with a wider range of mishaps, including the failure of a very large financial or non-financial firm . The subsequent practice of central banks has generally been to provide short-term loans to solvent banks to tide them over temporary liquidity difficulties, and to provide or arrange longer-term loans to avert failures that would be large enough to threaten the stability of the banking system. Concern about the possibility that major bank failures in one country might infect others and destabilise the world's financial systems, as had happened in the Great Depression of the 1930s, led to international consultation, as a result of which, in 1988, the Basel Committee for International Banking Supervision of the Bank for International Settlements recommended limits upon banks' capital adequacy ratios which took account of the riskiness of their assets. Their recommendations have since been implemented by most central banks.

Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending. In the 1980s, however, there was extensive deregulation of the banks with the intention of increasing competition and improving efficiency . Reserve requirements were relaxed and restrictions upon the range of their financial activities were generally relaxed or removed . There followed an extensive restructuring of most of the world's major financial systems in which investment banking and branch banking organisations were merged, banks became closely involved in a wide range of non-banking activities such as mortgage lending and insurance, and new financial institutions came into being whose activities interacted with the new activities of the banking system. In 1997 an inquiry set up by the Australian Government recommended that, in view of the growing interdependence of the banking system with the remainder of the financial system, they should all be regulated by a single agency and that recommendation has since been followed by Japan and many European countries . In Britain the Bank of England retained its responsibility for the provision of emergency liquidity as "lender of last resort" but its regulatory responsibilities were transferred to the existing Financial Services Authority . Concern about the possible effect of these further developments upon the stability of the international financial system led to the precautionary activities of the international regulatory bodies that are described in the article on international economics. Among them, a revised version of the Basel Committee's recommendations, known as "Basel II" , which required central banks to ensure that banks were operating adequate risk-management systems, took effect at the beginning of 2008.

How it all worked out

Imperfect markets

The importance of the efficient market hypothesis lies not so much in what it says about investment analysts, as in the implications of its embodiment in subsequent theories: a risk-assessment procedure that is based upon a hypothesis that only holds true most of the time may be expected to have limited reliability. Questions about its usefulness in such applications arise mainly from the known incidence of irrational behaviour. The existence in the market of noise traders need not invalidate the hypothesis, provided that most traders act rationally and that those who do not, make only random mistakes. But two events suggest that, even if it nearly always holds true, there can be important exceptions in which those provisos are breached. They are the stock market crash of 1987 and the internet bubble of the 1990s. In defence of the hypothesis, Burton Malkiel argues that the 1987 crash can be explained mainly (but not entirely) in terms of rational behavour, notes that professional analysts were very much involved in the creation of the internet bubble, and rests his defence upon the observation that bubbles are exceptional . The findings of behavioural finance studies suggest, however, that occurances of that sort are to be expected. The innate characteristics of the human mind have been shown to be responsible for habitual and persistent judgmental mistakes , of which some, such as "information cascades" might be expected to lead to non-random price-movements - and there have been many instances of cascades and herding behaviour in financial markets.

Faulty insurance and capital mismanagement

The massive expansion in the use of portfolio insurance which occurred in the 1980s, ended when its shortcomings were exposed by the stock exchange crash of 1987. Used by a privileged few, it had been very effective, but its widespread use eventually violated some of the Black-Scholes assumptions upon which it was based. It was designed to cope with the fundamentally directionless price fluctuations, characterised mathematically as a random walk, and was ill-adapted to deal with a persistent downward trend. Moreover, the short selling which it required could not be achieved in the absence of willing buyers, which cease to be available at times of panic. In 1987, massive losses resulted from its use. Expert opinion differed as to whether it was among the causes of the crash, but it is generally accepted that it increased its severity. . In grossly simplified terms, it could be seen as a sophisticated form of the stop loss policy under which investors automatically respond to falling prices by selling stock, thereby contributing to the downward trend. The financial fragility of highly-geared hedge funds was subsequently demonstrated by the spectacular failure of "Long Term Capital Management" (LTCM). Launched in 1994, LTCM immediately attracted investors in other financial intermediaries, including many large investment banks, and raised $1.3 billion at launch. It was spectacularly successful for four years, but by 1998 it had lost over $4 billion and a private sector rescue was organised by the Federal Reserve Bank. There are differing accounts of the complex series of events that led to its failure, , but it is generally agreed that it was finally brought down by a lack of liquidity. LTCM's assets eventually yielded a small profit, suggesting that it might not have needed rescue had it not been temporarily unable to meet its financial obligations because it could not find buyers for its assets when it needed them.

Financial crises and the danger of systemic failure

The fact that the Federal Reserve Bank organised the rescue of LTCM was a recognition that it was a significant component of what had become a truly complex interactive system; - and a recognition of that system's fragility. Walter Bagehot had warned, over a hundred years previously, of the devastating effect upon the economy of a "run on the banks", and the consequent withdrawal of the credit upon which the non-financial sector depends, and the eminent United States economist, Ben Bernanke later suggested that banking failures had been responsible for the depth and longevity of the Great Depression of 1929 . The devastating effect of the failures of their recently deregulated banking systems upon the economies of the Asian "tigers" had provided a further warning of what could happen . Although LTCM was not a bank, it was feared that its linkages with the banks through loans and investments were so strong that its failure could threaten their ability to provide liquidity on request to the rest of the economy. The Bank was criticised for that rescue on the grounds that it created a moral hazard by motivating financial intermediaries to take unwarranted risks in the expectation of rescue if things went wrong; and for that reason regulatory authorities worldwide have since been reluctant to act in the absence of systemic danger. (Policy reasons other than the fear of systemic failure had been behind the United States government's earlier $150 billion rescue of the "Savings and Loans" domestic mortgage-lenders .) In Britain, no attempt was made to rescue Barings, which was Britain's oldest investment bank, when it failed for the second time in 1995 , and moral hazard considerations delayed the rescue of the Northern Rock bank in 2007 . In the United States, there were no more bank rescues until liquidity problems crippled its fifth largest investment bank, Bear Stearns in 2008.

The troubles at Northern Rock and Bear Stearns both had their origins in the 2007 sub-prime mortgages crisis in the United States . In earlier days the consequences of a such a crisis would be confined to those immediately involved, but financial innovations such as securitisation have since spread the consequences of loan defaults over a wide range of banks and other financial intermediaries. Multiple defaults by house-owners caused widespread uncertainty about the value of assets relating to the US housing market and a general unwillingness to offer cash in exchange for them. As a result, a variety of organisations, that would otherwise be regarded as solvent with more than adequate reserves, found themselves unable to meet their financial obligations because they could not exchange enough of their assets for cash. An international working group attributed the crisis to inadequate supervision by the regulatory authorities in the United States and elsewhere; to faulty risk-management by firms, accentuated by bonus schemes that encouraged disproportionate risk-taking; and to undue reliance upon inaccurate assessments by credit-rating agencies. .

A survey of the 2007-2008 financial crisis by the former chairman of Britain's Financial Services Agency concluded that the international regulatory system was flawed, and recommended a strengthening of the Financial Stability Forum , and that organisation has itself put forward proposals for change , and former Federal Reserve Bank chairman Paul Volcker described the crisis as "the culmination... of at least five serious breakdowns of systemic significance in the past 25 years" .