Financial Economics

Financial economics deals with the distribution of financial reserves across physical locations and across durations of time. Financial economics is the subject area that concerns the valuation of risk, securities and returns. This subject also influences the outcome of investment decisions and financing of companies. Financial economics is a subdivision of economics and employs equivalent economic tools and concepts. The subject makes extensive use of mathematical methods and econometrics.

Financial economics is principally applied in the following areas: saving, borrowing, insuring, lending, asset management, budgeting, and diversifying. Uncertainty of future events makes financial economics an important decision-making component on the allocation of resources. Financial economics tries to solve practical financial problems like the investment portfolio to be held by an individual, whether a company should borrow or issue shares for financing its operations or the determining of the prices of financial assets like bonds, currencies and stocks.

CAPM

CAPM or Capital Asset Pricing Model is a technique of valuing any investment. CAPM is used in conjunction with a Discounted Cash Flow (DCF) model that includes a risk adjusted discount rate. The discount rate formula employed in a CAPM DCF is: r = r_f + ( β × (r_m – r_f) )

where r_f denotes the risk free rate, r_m is the expected return from market, and β is the specific security being valued or beta of cash flows. Beta is quantum of risk that an investment would carry in a diversified portfolio.

Black-Scholes Formula

Black-Scholes formula is employed for valuation of options. This formula takes the following form:

sN(d₁)- e^{-r (T-t)}XN(d₂)

where s is underlying security price, e is mathematical constant, r is risk free rate of return, N(X) represents cumulative standard normal distribution of X, X is option’s exercise price,T is time of expiry of specific option and t is time of valuing the option.

Cite Term

Definition Sources