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 investment choices facing individuals

The efficient markets 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. The answer depends upon the construction that is placed upon the term “efficient”. For example, some definitions of efficient markets do not exclude the well-known presence of many irrational noise traders. It has also been argued that the success of Warren Buffet and a few others need not invalidate the proposition that the average investment analyst does not consistently do better than the stock market index. 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. Most economists now accept the hypothesis as being generally true in that sense, despite the occurrence of several large departures from a true valuation, such as the dotcom bubble of the 1990s and the subsequent subprime mortgages crisis. There are still dissenting voices, however, including the widely-respected Joseph Stiglitz . 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 - a method that is known as the dividend discount model when applied to shares. 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. Equities may be expected to provide greater returns than government bonds in order to compensate investors for the greater risk involved, and the difference is termed the “equity risk premium”. A theorem developed by the economist William Sharpe proves that, under ideal circumstances, the extent to which the rate of return of a given share exceeds the current risk-free rate of interest is proportional to the equity market’s risk premium multiplied by a factor related to the covariance of that share's price movements with the price movements of the equity market as a whole. That theorem is known as the Capital Asset Pricing Model and the multiplication factor for a share is known as that share's beta. (For the mathematical form of the model and the formal definition of beta, see the "tutorials" subpage)