Economics of Finance: Definition, Ideas, and Subject Areas
Financial economics and behavioral economics are two interconnected fields that play a crucial role in shaping investment decisions and understanding financial markets.
Financial Economics
Traditionally, financial economics relies on models such as the efficient-market hypothesis (EMH) and modern portfolio theory (MPT), which assume that investors are rational agents who optimize portfolios based on available information and that markets efficiently reflect all public information. The field is usually applied to investment decisions in financial markets such as the stock market, foreign exchange market, and debt securities market.
To study financial economics, one needs a basic understanding of microeconomics, accounting, and basic probability and statistics. The focus is on making decisions based on two primary considerations: risk and return. The Capital Asset Pricing Model (CAPM) is a model for evaluating the risk and return of risky assets, useful for determining benchmarks and assessing the return rate on an asset's investment.
Behavioral Economics and Behavioral Finance
However, the relationship between financial economics and behavioral economics is that behavioral economics extends and challenges traditional financial economics by incorporating psychological insights into how people actually make financial decisions. This often deviates from the purely rational assumptions of classical financial theory.
Behavioral economics studies the influence of cognitive biases, emotions, and heuristics on individual and institutional decision-making, showing that investors often behave irrationally—exhibiting phenomena such as loss aversion, overconfidence, herd behavior, and other systematic errors that lead to market inefficiencies. Behavioral finance is a specific subfield that applies behavioral economics principles directly to the study of financial markets and investor behavior.
In practice, behavioral economics informs financial planning by helping professionals account for clients’ emotional and cognitive biases, improving strategies to manage risk and decision-making in volatile markets. It also motivates methods like nudge theory to subtly influence financial behavior in beneficial ways.
Comparison of Aspects
| Aspect | Financial Economics | Behavioral Economics / Finance | |-------------------------|----------------------------------------------------|-------------------------------------------------------------| | Assumption on investors | Rational, utility-maximizing | Irrational, influenced by biases and heuristics | | Market view | Efficient markets reflect all public information | Markets can be inefficient due to behavioral biases | | Decision influences | Based on objective data and mathematical models | Influenced by psychology, emotions, social factors | | Application | Portfolio theory, asset pricing, risk management | Explaining anomalies, improving financial planning, nudges |
In summary, behavioral economics enriches financial economics by providing a more realistic model of human behavior that better explains and predicts actual financial decisions and market phenomena.
Key Concepts
- The demand for money originates from the same three sectors (individuals, businesses, and government), with individuals borrowing for expenses like buying a house or paying for education, companies borrowing for capital equipment or working capital, and the government borrowing to cover the budget deficit.
- Suppliers of funds in financial economics can be investors, bondholders, shareholders, lenders, or creditors.
- Risk premium is an extra return to compensate for additional risks such as inflation, liquidity risk, default risk, and maturity risk.
- The present value of $60 bills in 2030 can be calculated using a discount rate.
- The value of money changes over time due to factors like inflation, and to calculate its future value, compound interest can be used.
- Interest is the price of money, and the interest rate is determined by the minimum return (real interest rate) and a risk premium.
- The money supply comes from the business sector, household sector (individuals), and government sector.
- Portfolio management is a concept to optimize returns and minimize risk by diversifying and allocating money to various financial assets.
- The analysis of an asset's fair value and the amount of cash that can be made from an investment is a chapter of financial economics study.
- In financial economics, money is the object of supply and demand, and interest represents the price of money.
- Financial economics focuses on the monetary side of an economy, intersecting with financial studies, financial markets, and economics.
- Compound interest is the interest rate attached to money to convert future value to present value, while a discount rate is used for the opposite.
- The formula for CAPM is R = R*(Beta* (R-R)), where R is the expected return for an asset, R* is the risk-free rate, Beta is the asset's beta, and R is the expected market return.
- The study of financial economics provides knowledge for making decisions about money, including options for allocation, calculating return and risk, understanding risk factors, and determining the fair value of assets.
Investing decisions in financial markets are influenced by both financial economics, which relies on models like the efficient-market hypothesis and modern portfolio theory, and behavioral economics, which considers psychological factors like cognitive biases and emotions that can lead to irrational investment behavior.
Behavioral economics informs financial planning and improves strategies to manage risk and decision-making in volatile markets by accounting for clients' emotional and cognitive biases, as well as motivating methods like nudge theory to subtly influence financial behavior in beneficial ways.
