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Financial Economics

- Aggregate Supply and Demand
- AD AS Model
- Aggregate Demand
- Aggregate Demand Curve
- Aggregate Expenditures Model
- Aggregate Supply
- Long Run Aggregate Supply
- Long Run Self Adjustment
- Macroeconomic Equilibrium
- National Economy
- Short Run Aggregate Supply
- Supply Shock
- The Long-Run Aggregate Supply Curve
- Economic Performance
- Aggregate Production Function
- Business Cycle
- Business Cycle Graph
- Business Cycle and Economic Indicators
- Business Cycles in the United States
- Causes of Inflation
- Consequences of Inflation
- Consequences of Unemployment
- Consumer Price Index
- Costs of Inflation
- Deflation
- Disinflation
- Economic Cycle
- Economic Growth
- Economic Instability
- Effects of Inflation
- Falling Prices
- Forecasting Business Cycles
- Frictional Unemployment
- Growth Rate
- Growth and Development
- Hyperinflation
- IS LM Model
- Inflation
- Inflation and Deflation
- Macroeconomic indicators
- Market Basket
- Measures of Development
- Measures of Inflation
- Measures of Unemployment
- Moderate Inflation
- Monetarist Theory of Inflation
- Natural Rate of Unemployment
- Natural Resources
- Nominal GDP vs Real GDP
- Okun's Law
- Population and Economic Growth
- Price Indices
- Shoe Leather Costs
- Structural Unemployment
- Types of Inflation
- Types of Unemployment
- Unemployment
- Unemployment Rate
- Unit of Account Costs
- Financial Sector
- Arbitrage
- Bank Interest Rates
- Bank Reserves
- Bank Runs
- Banking
- Banking in America
- Banks
- Capital Market
- Circular Flow of Money
- Commercial Banks
- Credit
- Credit Creation
- Demand in the Loanable Funds Market
- Equilibrium in Money Market
- Equilibrium in the Loanable Funds Market
- Evolution of Money
- Expansionary and Contractionary Monetary Policy
- FED Monetary Policy
- Financial Assets
- Financial Economics
- Financial Intermediaries
- Financial Markets
- Financial System
- Fisher Effect
- Fractional Reserve System
- Functions of Central Banks
- Human Capital
- Inflation Targeting
- Interest Rates
- Loanable Funds Market
- Long Run Interest Rate
- Measures of Money Supply
- Monetary Neutrality
- Monetary Policy
- Monetary Policy Tools
- Money
- Money Creation
- Money Definition and Function
- Money Demand Curve
- Money Management
- Money Market
- Money Multiplier
- Money Supply
- Nominal vs Real Interest Rates
- Other Financial Institutions
- Personal Finance Economics
- Present Value
- Present Value Calculation
- Regulation of Financial System
- Risk and Return
- Saving and Investing
- Savings and the Financial System
- Security Market Line
- Short Run Interest Rate
- Supply of Loanable Funds
- Taylor Rule
- The European Central Bank
- The Federal Reserve
- Types of Banks
- Types of Money
- Zero Lower Bound
- International Economics
- Appreciation and Depreciation
- BOP Current Account
- Balance of Trade
- Barriers to Trade
- Comparative Advantage
- Comparative Advantage vs Absolute Advantage
- Crisis in Venezuela
- Devaluation and Revaluation
- Developing Countries
- Economic Development
- European Single Market
- Exchange Rate
- Exchange Rate and Net Exports
- Factors Influencing Foreign Exchange Market
- Fixed Exchange Rate
- Floating Exchange Rate
- Foreign Exchange Market
- Free Trade
- Free Trade Zone
- Funding Economic Development
- Global Economic Challenges
- Globalisation
- Import Quotas
- Inflation and Real Exchange Rates
- International Capital Flows
- International Trade
- Population Growth
- Protectionism
- Purchasing Power Parity
- Real Exchange Rate
- Specialisation
- The Demand for Resources
- The Equilibrium Exchange Rate
- Trade Agreements
- Trade Deficit and Surplus
- Trading Blocs
- World Trade Organisation
- Introduction to Macroeconomics
- Macroeconomic Issues
- Keynesian Economics
- Rational Expectations
- Real Business Cycle Theory
- Stimulus Package
- Supply-Side Economics
- Macroeconomic Policy
- Automatic Stabilizers
- Budget Balance
- Budget Deficit
- Budget Surplus
- Classical Model of Price Level
- Crowding Out
- Cyclically Adjusted Budget Balance
- Deadweight Loss
- Debt
- Deficits and Debt
- Demand-side Policies
- Economic Growth and Public Policy
- Effective Taxation
- Expansionary and Contractionary Fiscal Policy
- Federal Government Revenue Sources
- Federal Taxes
- Fiscal Multiplier
- Fiscal Policy
- Fiscal Policy Actions in the Short Run
- Government Income and Expenditure
- Government Revenue
- Government Spending
- Implicit Liabilities
- Incidence of Tax
- Inflation Tax
- Local Government Expenditures
- Long-Run Consequences of Stabilization Policies
- Long-Run Phillips Curve
- Lump Sum Tax
- Marginal Tax Rate
- Monetary Policy Actions in the Short run
- Money Growth and Inflation
- National Debt
- Phillips Curve
- Principles of Taxation
- Progressive Tax System
- Short-Run Phillips Curve
- Sources of Revenue for Local Government
- Sources of Revenue for State Government
- Stabilization Policy
- State Government Expenditures
- State and Local Tax
- Supply-Side Policies
- Tax Compliance
- Tax Equity
- Taxation
- The Economics Of Taxation
- The Government Budget
- Types of Fiscal Policy
- Types of Taxes
- UK Taxes
- US Tax
- Macroeconomics Examples
- 2008 Financial Crisis
- Argentine Great Depression
- Chinese Economy
- Consequences of Brexit
- Cuban Economy
- Dot-com Bubble
- German Economy
- Great Depression
- Impact of Brexit on UK Economy
- Impact of Brexit on the EU Economy
- Indian Economy
- Japan Lost Decades
- Lebanese Economic Crisis
- Nordic Model
- Oil Crisis 1973
- Recessions
- Singapore Economy
- South Korea Economy
- Tulip Mania
- United Kingdom Economy
- World Economies
- National Income
- BOP Financial account
- Balance of Payments
- Calculating Real GDP
- Circular Flow of Income
- Consumer Spending
- Consumption Function
- Expenditure Approach
- Expenditure Multiplier
- GNP
- Gross Domestic Product
- Investment Spending
- Measured GDP
- Measures of National Income and Output
- Measuring Domestic Output and National Income
- Multipliers
- National Accounts
- Output Expenditure Model
- Real vs Nominal Value
- Tax Multiplier

Raise your hand if you would like to make money without working. If you raised your hand, you are not alone! People all over the world make money every day without working. How do they do it? By investing! It may seem easy to buy stock in a company and just sit back and think the money is going to roll in, but it's not that easy. As with anything, to succeed in investing, you need to know what you are doing. Economists, financial analysts, stock brokers, and many other financial professionals know what they are doing because they understand financial economics. If you are ready to learn more about financial economics and how it can help you to make money without working, read on!

The definition of **financial economics** is the study of the preferences of investors and how they impact the trading and pricing of **financial assets** like bonds, stocks, and mutual funds. The two main investor preferences are a high **rate of return** and the least amount of **risk** and uncertainty as possible.

Financial economics focuses on the investments that firms and individuals make. By knowing investor preferences, as well as the interest rate and time frame of an investment, investors can use financial economics to accurately price assets in the market and choose the ones that best fit their needs.

**Financial economics** is the study of the preferences of investors and how they impact the trading and pricing of financial assets.

**Financial assets** include stocks, bonds, mutual funds, and real estate.

Let's take a look at some of the principles of financial economics.

There are several **principles** of financial economics. These include the **time value of money**, **compound interest**, **present value**, **rate of return**, **arbitrage**, and **risk**.

Let's take a look at each of these in turn, and then see how investors use this information to compare risky assets and compute expected returns.

The first principle of financial economics is the **time value of money**, which is the opportunity cost of receiving money in the future as opposed to today. Money is more valuable the sooner it is received because it can then be invested and earn compound interest.

The **time value of money** is the opportunity cost of receiving money later rather than sooner.

**Compound interest** is the second principle of financial economics. Compound interest is interest earned on the original amount invested and the interest already received. The interest rate and the frequency at which it compounds (daily, monthly, quarterly, yearly) determines how fast an investment increases in value over time.

**Compound interest **is interest earned on the original amount invested and the interest already received.

Take a look at the following equation:

\(\hbox{Equation 1:}\)

\(\hbox{Ending value} = \hbox{Beginning Value} \times (1 + \hbox{interest rate}) \)

\(\hbox{If} \ C_0=\hbox{Beginning Value,}\ C_1=\hbox{Ending Value, and} \ i=\hbox{interest rate, then:} \)\(C_1=C_0\times(1+i)^t\)

\(\hbox{for 1 year}\ t=1\ \hbox{, but t can be any number of years or periods}\)

Thus, if we know the beginning value of the investment, the interest rate, and the number of compounding periods, we can easily use Equation 1 to calculate the ending value of the investment.

This brings us to the third principle of financial economics - present value. **Present value** is the present-day value of future cash flows (earnings or costs).

By rearranging Equation 1, we can also calculate \(C_0\) if we know \(C_1\):

\(C_0= \frac {C_1} {(1+i)^t}\)

More generally, for any given number of years t, the equation is:

\(\hbox{Equation 2:}\)

\(C_0= \frac {C_t} {(1+i)^t}\)

This is the general Present Value formula.

**Present value** is the present-day value of future cash flows.

By applying this formula to all expected future cash flows of an investment and summing them up, investors can accurately price assets in the market. For a risk-free asset, the appropriate price is the present value of future expected returns. Pricing risky assets is a bit more complicated.

To learn more, read our explanation about Present Value!

The fourth principle of financial economics is the rate of return. The **rate of return** is the percentage change in the value of an asset compared to the original price paid. If \(P_0\) is the purchase price and \(P_t\) is the price \(t\) years later, then the rate of return is calculated using the following equation:

\(\hbox{Equation 3:}\)

\(\hbox{Rate of return}= \frac {P_t-P_0} {P_0}\)

The **rate of return **is the percentage change in the value of an asset compared to the original price paid

Stating returns on an investment in percentage terms rather than dollar or other currency terms allows investors and analysts to compare performance across all different kinds of assets and asset classes.

One thing to note is that, all else equal, for fixed-income assets (assets with constant cash flows), the higher the price paid for an asset, the lower the rate of return. That is because the same numerator (the cash flow) will be divided into a bigger denominator, resulting in a lower rate of return.

The fifth principle of financial economics is arbitrage. **Arbitrage** is the buying and selling of assets that lead to an equalizing of the average expected rates of return on identical or very similar assets. Let's break this down a bit.

Suppose there are two companies, Company A and Company B. Everything between them is nearly identical except for their rates of return. Let's say company A currently has a rate of return of 10% while Company B has a rate of return of 20%. What do you suppose investors in Company A will do?

All else equal, they would rather invest in Company B, so they will sell their shares in Company A, pushing down the price and increasing the rate of return. Meanwhile, greater demand for Company B shares will push up its price and decrease its rate of return.

This will continue until the rates of return are identical, which should be the case since everything else about the companies is the same. Thus, if an asset is mispriced in the market, it won't take long for savvy investors to find it and make a quick profit, but the opportunity may be very short-lived, as in a matter of minutes or even seconds.

**Arbitrage** is the buying and selling of assets that lead to an equalizing of the average expected rates of return on identical or very similar assets.

To learn more, read our explanation about Arbitrage!

The sixth principle of financial economics is risk. **Risk** is defined as the uncertainty about future payments from investments. Although there is a risk that the future will be worse than expected, there is also a risk that the future will be better than expected. Even so, investors try to reduce the amount of risk they are exposed to as much as possible.

**Risk** is the uncertainty about future payments from investments.

Things that could make an investment risky include company management, industry problems, the economic outlook, a change in government policy, a change in interest rates, the weather, natural disasters, and so on. Any investment where future payments are not guaranteed to be paid should be considered risky, but some investments are certainly riskier than others.

One important way investors can reduce their risk is through **diversification**, which is the process of buying different kinds of assets in different categories with different risk levels.

If you held stock in only Company A and they had a bad year and the price plunged, you would not be very happy. However, if along with Company A you also had Company B and Company C in your portfolio, and they had average years, only one-third of your portfolio would suffer. Furthermore, if Company B and Company C had good years and their stock prices increased, your diversified portfolio would likely show a net increase, as the price increases of Company B and Company C outweighed the price decrease of Company A. That's diversification.

The type of risk that can be diversified away in this manner is called **diversifiable risk** (or idiosyncratic risk).

**Diversifiable risk (idiosyncratic risk)** is specific to each investment and can be diversified away in a well-diversified portfolio.

Still, even if you had a well-diversified portfolio, there is still some risk associated with the portfolio. Let's say all three of these companies are in the same country and the economy enters a recession. Regardless of how well diversified your portfolio is, all three of these companies feel the impact of a recession, and in that case, all three stock prices will fall at the same time.

Or let's say there is a corporate profit tax increase or an increase in interest rates. Most likely, these changes will affect all three companies in the same way. Thus, there is some risk that cannot be diversified away, and this is called **non-diversifiable risk** (or systemic risk).

**Non-diversifiable risk (systemic risk) **is the type of risk that cannot be diversified away.

One important thing to note is that all of an investment's diversifiable risk can be diversified away. This means that when choosing new investments for a portfolio that is already diversified, investors need only worry about non-diversifiable risk, which they can then compare to the potential returns to determine if the investment would be a wise choice.

To learn more, read our explanation about Risk!

So how do economists and financial analysts compare risky assets to determine which ones to add to a portfolio? They use two measures: the **average expected ****rate of return** and **beta**.

The average expected rate of return is the weighted average of expected returns, with the weights being the probability that a certain return will occur.

For example, if an investment has a 60% probability of having a 10% return and a 40% probability of having a 20% return, then the average expected rate of return is as follows:

\(\hbox{Average expected rate of return}=0.6\times10\%+0.4\times20\%=6\%+8\%=14\%\)

Beta is a statistic that measures the non-diversifiable risk of a portfolio relative to the market portfolio, which is a portfolio that contains every financial asset available in the market. Since the market portfolio contains every available asset, it is useful for comparing the non-diversifiable risk of an asset or portfolio, as all the diversifiable risk has been eliminated.

The market portfolio's beta is equal to 1. A beta below 1 means an asset or portfolio is less risky than the market, and a beta above 1 means it is more risky than the market. An asset with a beta of 0.2 has one-fifth the non-diversifiable risk of the market, while an asset with a beta of 2.0 has twice the non-diversifiable risk of the market. Similarly, the asset with a beta of 2.0 has 10 times the non-diversifiable risk as the asset with a beta of 0.2. Thus, beta allows comparison to both the market and other assets and portfolios regarding risk.

A fundamental truth about risk and return is that riskier assets have lower prices and provide higher average expected rates of return than less risky assets. Since investors dislike risk, they need to be compensated for buying riskier assets, and this compensation comes in the form of higher average expected returns. This is true for all assets of any type in any market.

However, there is one asset with a different risk profile. Short-term U.S. Treasury bills have maturities between 4 and 52 weeks. Since there is virtually no chance the U.S. government will default on its interest payments in such a short period of time, these assets are considered risk-free. Still, they don't pay zero percent interest, as one might expect. The interest rate paid on these assets is to compensate for time preference, or the inclination of people to want to consume today versus in the future. In order to compensate investors for giving up their money, even for a short period of time, these assets still need to pay at least a little bit of interest. But there is still the risk that the Federal Reserve will change interest rates, which affects not only the risk-free rate, but also the prices of all other assets.

Although U.S. Treasury bills only compensate for time preference, all other assets must compensate for both time preference and non-diversifiable risk.

In equation form:

\(\begin{align}& \hbox{Average expected rate of return} = \\& =\hbox{rate to compensate for time preference}\ + \\& + \hbox{rate to compensate for non-diversifiable risk}\end{align}\)

The rate to compensate for time preference is the risk-free rate R_{f,} and the rate that compensates for non-diversifiable risk is called the risk premium. Thus the equation becomes:

\(\hbox{Average expected rate of return}=R_f+\hbox{risk premium}\)

Now, the risk premium will depend on how large the asset's beta is. A higher beta requires a higher risk premium. If we create a graph with the x-axis being beta and the y-axis being the average expected rate of return, and plot two points (one with a beta of 0 and one with a beta of 1.0, and draw a line between the two points, we get what is called the **Security Market Line** (SML).

See Figure 4 below. At the point where beta is 0, the average expected rate of return is simply the risk-free rate. At the point where beta is 1.0, we have the average expected rate of return of the market portfolio, which consists of the risk-free rate plus the risk premium. As you can see, the risk premium is larger for higher beta assets and lower for lower beta assets.

In financial economics, the risk premium is defined as the asset's beta multiplied by the expected return on the market portfolio minus the risk-free rate.

Thus, the SML in equation form is:

\(\hbox{Equation 4:}\)\(E(R_i)=R_f+\beta_i\times[E(R_M)-R_f]\)Where:\(E(R_i)\) - average expected rate of return on asset i\(R_f\) - the risk-free rate\(\beta_i\) - asset's beta\(E(R_M)\) - expected return on the market portfolio

All assets in the market lie somewhere on the SML. If an asset isn't on the SML, arbitrage will quickly move it back onto the SML. If two assets with the same beta have different average expected rates of return, investors will sell the lower returning asset, thus reducing its price and increasing its expected return, and buy the higher returning asset, thus increasing its price and reducing its expected return. This will continue until all assets with the same beta have the same average expected rate of return, thus all lying on the SML.

Two things can alter the SML. First, if the Federal Reserve changes interest rates, the risk-free rate will change, thus shifting the SML up or down. Second, if investors become more risk averse, the slope of the SML will become steeper, while if investors become less risk averse, the slope of the SML will become flatter. This is why investors pay close attention to the Federal Reserve's actions as well as economic trends, because they greatly impact asset prices and average expected rates of return.

To learn more, read our explanation about the Security Market Line!

Let's take a look at some financial economics examples. We will cover examples of compound interest, asset pricing, rate of return, and average expected rate of return.

Example 1 - Compound Interest

\(\hbox{If} \ C_0=\hbox{Beginning Value,} \ C_t=\hbox{Ending Value, and} \ i=\hbox{interest rate, then:} \)

\(C_t=C_0 \times (1 + i)^t \)

\(\hbox{If} \ C_0=$1,000, \ i=5\%, \hbox{and} \ t=10 \hbox{ years, what is the value of the investment} \)\(\hbox{after 10 years?} \)

\(C_{10}=$1,000 \times (1 + 0.05)^{10}=$1,628.89 \)

Example 2 - Pricing an asset using the present value equation

\(\hbox{The simple present value equation is:} \)

\(C_0=\frac{C_t} {(1 + i)^t} \)

\(\hbox{If} \ C_t=$1,000, i=8\%, \hbox{and} \ t=5 \hbox{ years, what is the present value of this asset?} \)

\(C_0=\frac{$1,000} {(1 + 0.08)^5}=$680.58 \)

Example 3 - Pricing an asset with multiple cash flows using the present value equation

\(\hbox{The present value equation can also be used to price an asset} \) \(\hbox{with multiple cash flows.} \)

\(\hbox{Let's look at an asset with different cash flows over 3 years.} \)

\(\hbox{Suppose} \ C_1 = $50, C_2 = $50, C_3 = $1,050, \hbox{and} \ i = 10\%, \hbox{then:} \)

\(C_0=\frac{C_1} {(1 + i)^1} + \frac{C_2} {(1 + i)^2} + \frac{C_3} {(1 + i)^3} \)

\(C_0= \frac{$50} {(1.1)} + \frac{$50} {(1.1)^2} + \frac{$1,050} {(1.1)^3} = $875.66 \)

Example 4 - Calculating a simple rate of return

\(\hbox{If we know the purchase price} \ P_0 \hbox{ and the sale price} \ P_t \hbox{ of an asset,} \)\(\hbox{we can calculate the rate of return.} \)

\(\hbox{Rate of Return =} \frac{P_t - P_0} {P_0} \)

\(\hbox{Suppose you purchased an asset for } $100 \hbox{ and sold it for } $140. \)\(\hbox{What is the rate of return?} \)

\(\hbox{If} \ P_0 = $100, \hbox{ and} \ P_t = $140, \hbox{then:} \)

\(\hbox{Rate of Return}= \frac{$140 - $100} {$100} = \frac{$40} {$100} = 40\% \)

Example 5 - Calculating the average expected rate of return using the Security Market Line

\(\hbox{We can calculate the average expected rate of return for an asset using} \)\(\hbox{ the Security Market Line equation if some other information is known.} \)

\(\hbox{The equation is:} \)

\(R_i = R_f + \beta \times (R_M - R_f) \)

\(\hbox{If} \ R_f = 1\%, \beta = 2, \hbox{and} \ R_M = 8\%, \) \(\hbox{what is the average expected rate of return for this asset?} \)

\(R_i = 1\% + 2 \times (8\% - 1\%) = 1\% + 2 \times 7\% = 1\% + 14\% = 15\% \)

The scope of financial economics includes many ways for investors to assess investments for the risk and expected rates of return. Understanding the concept of the time value of money helps to understand the concept of compound interest. Understanding compound interest helps to understand how to calculate the present value of cash flows, and thereby the price of an asset. Once we know the beginning and ending price of an asset, we can calculate the rate of return. Arbitrage helps to understand that identical assets should have the same average expected rates of return. Understanding the two types of risk helps to calculate the average expected rate of return for a given risk level. With a given risk level and the average expected rate of return known, investors can then use this data to compare risky assets and choose the ones that best fit their needs.

Armed with all of this information, investors have many assets they can choose from to add to their portfolios. Some of the most common investments are stocks, bonds, and mutual funds. All three of these types of investments share three characteristics:

- Investors must pay a market-determined price to acquire them
- Owners receive future payments
- Future payments are usually risky

Let's now take a closer look at each of these common assets in detail.

Bonds are fixed-income investments issued by companies and governments that pay interest over time plus the principal (initial investment) that is repaid at maturity. The maximum gain is the interest payments plus any gain in price if it is sold before maturity, while the maximum loss is the difference between the purchase price and sale price if sold at a loss, or any principal and interest that isn't covered in bankruptcy. Gains come from interest payments and any increase in the price of the bond upon sale. Investors can sell at any time. The main risks are default and bankruptcy (investors may not get their entire principal back if asset sales can't cover debts). Bonds are more predictable than stocks because the amount and timing of interest payments are known, as is the maturity date.

Stocks are shares of ownership in a company. Investors are entitled to a share of the company's earnings and votes at shareholder meetings about management, operations, and company direction. The maximum gain is unlimited, while the maximum loss is the entire investment (limited liability rule - investors don't have to cover losses beyond their initial investment in case of bankruptcy). Gains come from periodic dividend payments and capital gains, which is an increase in the share price. Investors can sell at any time. The main risks are a decline in the share price and bankruptcy (bondholders are paid first in bankruptcy, if there is nothing left after bondholders are paid shareholders get nothing). Stocks are less predictable than bonds because they depend on profits, which are volatile due to changes in the business cycle, management, and government policy.

Mutual funds are a portfolio of stocks and/or bonds. Fund managers generally stick to one or a few categories (i.e. technology or airlines). Index funds track a certain group of stocks or bonds. Actively managed funds involve asset managers buying and selling assets frequently to generate high returns. With passively managed funds, assets are chosen to track an underlying index, so there is very little buying and selling with these funds. The maximum gain is unlimited, and the maximum loss is the entire investment, but this is rare due to diversification within the portfolio, and would only happen if the fund company itself went out of business.

Thus, the scope of financial economics encompasses the analysis of risk and return for assets, then applying that analysis to choose investments that will hopefully grow in value over time and provide financial security for investors in the future.

When comparing financial economics vs monetary economics, you will find that, although they are very different, there is a link between them.

Financial economics is the analysis of assets based on risk and return and the choosing of assets for a portfolio. Some of the main principles in financial economics are the time value of money, compound interest, present value, rate of return, arbitrage, and risk. These concepts and measures are used to analyze the average expected rate of return of an asset and its associated risk. This then allows investors to make well-informed decisions on which assets to include in their portfolios.

In contrast, monetary economics is the study of money. It looks at the functions of money, the creation of money, components of the money supply, the Federal Reserve system, and the financial system. It also includes understanding fractional reserve banking, the Federal Reserve's balance sheet, and the money multiplier. Furthermore, monetary economics includes learning about the goals and tools of monetary policy, the control of interest rates, and the effects of monetary policy on GDP and inflation.

To learn more, read our explanations about Money Creation, the Fractional Reserve System, the Money Multiplier, the Federal Reserve System, Money, and Monetary Policy!

There is a link between these two branches of economics, and that link is the risk-free rate. The risk-free rate is used to determine the average expected rate of return on a given asset with a given beta, which is a measure of risk relative to the market portfolio. Because the risk-free rate itself is impacted by monetary policy, the Federal Reserve can affect asset returns and prices with its actions. In addition, monetary policy impacts the broader economy, which can lead to changes in investors' appetite for risk, and thereby average expected rates of return on assets and asset prices.

- Financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets like bonds, stocks, and mutual funds.
- The two main investor preferences are a high rate of return and the least amount of risk and uncertainty as possible.
- The principles of financial economics are the time value of money, compound interest, present value, rate of return, arbitrage, and risk.
- Economists and financial analysts compare risky assets using the average expected rate of return and beta.
- Financial economics and monetary economics are very different, but they are linked by the risk-free rate that determines average expected rates of return and asset prices.

The two main areas of financial economics are risk and return.

Eugene Fama is considered the father of financial economics.

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