Financial Economics
Financial economics studies how resources are allocated and risk is priced across time and uncertainty — the valuation of assets, the behaviour of financial markets, and the financing decisions of firms.
Scope
The field (JEL category G) covers portfolio choice and asset pricing, the efficiency of markets, derivatives, corporate finance and capital structure, financial intermediation, and, increasingly, behavioural finance.
Sub-topics
Core questions
- How should investors allocate wealth across risky assets?
- How are risk and return priced in equilibrium?
- Are asset prices informationally efficient?
- How should contingent claims (options) be valued?
- How do firms' financing choices affect their value?
Key concepts
- Risk and return
- Diversification
- Beta and systematic risk
- Capital structure
- Market efficiency
- Arbitrage
- Option pricing
- Cost of capital
Key theories
- Portfolio theory
- Markowitz formalized diversification through mean-variance optimization, making risk-return trade-offs the foundation of investment theory.
- Capital structure irrelevance
- Modigliani and Miller showed that, under idealized conditions, firm value is independent of capital structure, framing all subsequent corporate-finance theory.
- Asset pricing (CAPM)
- Sharpe's Capital Asset Pricing Model linked an asset's expected return to its systematic risk (beta), the canonical equilibrium pricing model.
- Market efficiency and option pricing
- Fama's efficient-markets hypothesis organized empirical finance, while Black and Scholes solved option valuation, founding modern derivatives theory.
History
Modern financial economics began with Markowitz's portfolio theory (1952), Modigliani-Miller's capital-structure theorems (1958), and the CAPM (Sharpe, Lintner) in the 1960s. The efficient-markets hypothesis (Fama) and Black-Scholes option pricing (1973) defined the 1970s. Since the 1980s, market anomalies, behavioural finance, and the analysis of financial crises have extended and challenged the efficient-markets paradigm.
Debates
- Are markets efficient?
- The efficient-markets hypothesis is challenged by documented anomalies and behavioural finance, with implications for active management and asset bubbles.
- Does capital structure matter?
- Modigliani-Miller's irrelevance benchmark frames debate over how taxes, bankruptcy costs, and information actually make financing choices matter.
Key figures
- Harry Markowitz
- Franco Modigliani
- Merton Miller
- William Sharpe
- Eugene Fama
- Fischer Black
- Myron Scholes
Related topics
Seminal works
- markowitz-1952
- modigliani-miller-1958
- sharpe-1964
- fama-1970
- black-scholes-1973
Frequently asked questions
- What is the efficient-markets hypothesis?
- The proposition that asset prices fully reflect available information, so that consistently 'beating the market' on a risk-adjusted basis is very difficult.
- What is beta?
- A measure of an asset's sensitivity to overall market movements — its systematic (non-diversifiable) risk, central to the CAPM.