Financial economics is the practice of analyzing the use and distribution of resources in economic markets. Financial decisions must often consider potential future events in the market, and that’s where financial economics comes into play. Financial economics studies the choices consumers, business managers, and government officials make to reach financial goals with limited or scarce resources.
Like general economics, financial economics uses theories of production, consumption, and distribution of goods and services in an attempt to understand how the use of resources—natural or technological—affects the lives of human beings and their environments. What makes financial economics a unique branch in the broader study of microeconomics is its focus on investment and market analysis, portfolio analysis, corporate finance, impacts of interest rates on investment, and the impacts of Federal Reserve Bank policy.
Financial economics may seem like an abstract, far away concept to the average consumer, but it actually plays a role in our daily lives. For example, someone who is buying and trading stocks may unwittingly use the principles of financial economics to weigh the potential risks and returns of their investment options.
This article will cover the study and application of financial economics, as well as careers you can pursue in this field.
Traditional economics focuses on exchanges of goods and services in which money is just one of the items being traded. Financial economics, in contrast, concerns exchanges in which money is the only item on both sides of the exchange.
The financial economist is different from the general economist in that their focus is on the exchange of money—and only money—and how time, uncertainty, and options play a role in the exchange.
Factors that go into making financial decisions include time, risk, opportunity, costs, and other information. The balance of these elements determines the incentive to make certain financial moves. Financial economics evaluates how these factors impact decision-making in order to supply investors with the tools and wisdom to make smart decisions.
Financial economics involves building analytical models to test the variables that affect financial decisions. Of course, mathematical models assume that humans always make rational decisions, although we know this is often not true. That said, financial economics takes acting irrationally into account as a potential risk factor.
Simply put, this derivative of economics combines the principles of economics and basic accounting concepts.
The major benefit of financial economics is that it equips investors with the ability to make informed, strategic decisions about investment options. Through financial economics, investors can evaluate the risk factors associated with their investments, the valuation of the assets, and the regulations in the markets. But it’s not just useful for individual investors. Financial economists are also known to help corporations with their finances and make recommendations to become more profitable.
There are two major aspects of financial economics called “present value” and “risk management diversification.” These aspects deal with the practical decision-making of investments.
1. Present Value: A universal truth every investor knows is that their money won’t have the same value in 20 years, even 5 years, that it does now. Money fluctuates in value; therefore, its purchasing power will too, over time. This is an important fact that informs financial economics theory.
The risk of inflation affects how a financial economist perceives present value. Inflation refers to the increase in value of goods and services over time. So how does this affect present value? As inflation increases, the value of a dollar decreases, so forecasting how this will affect present value is important to making informed investment decisions.
2. Risk Management and Diversification: Every financial decision ever made has involved some level of risk, some minuscule and others huge. A great example of fluctuation in varying magnitudes is the stock market. Anyone who keeps their finger on the pulse of the market knows that when trading stocks, one thing is certain: trends can change at any time. When potential returns from a stock are high, so is the risk. Smart investors should diversify their portfolio so that when one asset fails, another can compensate. In other words, financial economics preaches that you shouldn’t put all your eggs in one basket.
There are two different concepts when it comes to financial economics: portfolio theory and capital asset pricing model (CAPM). These concepts have to do with the theories and models related to investing.
1. Portfolio Theory: The portfolio theory of financial economics states that humans have an inherent aversion to high-risk situations, as well as situations that yield low returns. So, naturally, investors tend to avoid investment options that fit those descriptions. However, the investments with the biggest returns often pose higher risks. Similarly, investments with lower returns pose lower risks.
This concept suggests that assets are not just as good as they perform individually but interact with one another to create a strong portfolio that yields high returns for a certain level of risk. It’s the job of the investors to find the right combination of these assets.
2. Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model weighs the risks and returns of assets to determine their monetary value in the stock market. The purpose of this is to create appropriate compensation for investors who are trading the assets. CAPM even follows a specific formula for asset pricing.
A career in financial economics opens the door to many lucrative jobs. The U.S. Bureau of Labor Statistics reports that economists earn a median salary of $105,630 per year.
Some common jobs you can pursue as a financial economist include:
- Market research analyst
- Economic consultant
- Compensation and benefits manager
- Credit analyst
- Financial analyst
- Policy analyst
- Investment banker
- Portfolio manager
- Equity research associate
- Quantitative researcher
- Finance officer
- Corporate accountant
Financial economics is the study of the flow and exchange of money in financial markets. Without the principles and concepts of this branch of economics, investors wouldn’t have the strategic sense to weigh risks and returns associated with stock options. Financial economics considers not only risks and returns, but also human behavior and unpredictable changes in trends. While it may seem like a complicated topic, the study of financial economics affects the daily lives of many. This is especially true for those who trade in the stock market.
If this branch of economics is interesting to you and you want to pursue an interesting and stable career, you should explore relevant degree options in areas such as information technology or accounting. WGU’s degree programs will set you up for a lucrative and dynamic career in financial economics where you can increase your earning potential, job security, and opportunities for advancement by earning your bachelor’s degree in information technology or accounting. Bolstered by a competency-based, go at your own pace education style, you are empowered to complete your degree without uprooting your life.