Finance, Economics & Financial Economics: Back-To-School

imagesToday, we have chosen a very basic but, yet very interesting topic to discuss. “Financial Economics” Though seems 2 different branches but, when merged together it produces an extremely different class in finance. Today, we will start our discussion with what economics & finance mean independently, how both the classes are different from each other and finally what “Financial Economics” means to us.

Although Finance & Economics often taught and presented as very separate disciplines, economics and finance are interrelated and inform and influence each other. Investors care about these studies because they also influence the markets to a great degree.

ECONOMICS: It is a social science that studies the production, consumption and distribution of goods and services, with an aim of explaining how economies work and how their agents interact. When economists succeed in their aims to understand how consumers and producers react to changing conditions, economics can provide powerful guidance and influence to policy-making at the national level. Said differently, there are very real consequences to how a nation approaches taxation, regulation, and government spending; economics can offer advice and analysis regarding these decisions.

Economics can also help investors understand the potential ramifications of national policy and events on business conditions. Understanding economics can also give investors the tools to predict macroeconomic conditions and understand the implications of those predictions on companies, stocks, markets and so on. Being able to project that a certain set of government policies will stoke (or choke off) inflation or growth in a country can certainly help stock and bond investors position themselves appropriately.

FINANCE: Finance generally focuses on the study of prices, interest rates, money flows and the financial markets. Finance in many respects is an offshoot or outgrowth of economics, and many of the notable achievements in finance were made by individuals with economics backgrounds and/or positions as professors of economics. Thinking more broadly, finance seems to be most concerned with notions like the time value of money, rates of return, cost of capital, optimal financial structures and the quantification of risk.

While economics offers the pithy explanation that the fair price of an item is the intersection of supply, demand, marginal cost and marginal utility, that is not always very useful in actual practice. People want a number, and many billions of dollars are at stake in the proper pricing of loans, deposits, annuities, insurance policies and so forth. That is where finance comes into play – in establishing the theoretical understandings and actual models that allow for the pricing of risk and valuation of future cash flows. Finance also informs business managers and investors on how to evaluate business proposals and most efficiently allocate capital.

FINANCIAL ECONOMICS: Financial economics is the branch of economics concerned with the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment. It is additionally characterised by its concentration on monetary activities, in which money of one type or another is likely to appear on both sides of a trade.

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It studies the following:

1) Valuation of an asset:

  • How risky is the asset?
  • What cash flows will it produce?
  • How does the market price compare to similar assets?
  • Are the cash flows dependent on some other asset or event?

2) Financial markets and instruments:

  • Commodities
  • Stocks
  • Bonds
  • Money market instruments
  • Derivatives

3) Financial institutions and regulation

Conclusion: Economics posits that capital should always be invested in a way that will produce the best risk-adjusted return while, finance actually figures that process out. It is important for investors to avoid an arguments regarding economics and finance as, both are important and both have valid uses and applications. In many respects, economics is big picture (how a country/region/market is doing) and concerned about public policy, while finance is more company/industry-specific and concerned about how companies and investors evaluate and price risk and return.

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