Financial economics evaluates how economic resources are allocated within a market with uncertain conditions and applies economic methods in assessing the financial topics of time, transaction options, and information. This area of economics focuses on how interest rates, prices, shares, and financial variables interact. It intersects financial variables with economic variables and studies how a value of an asset is determined as well as topics in financial markets.
Financial economics constructs models to locate possible implications from theories and assumptions about the market. An example of an idea in financial economics is the Capital Asset Pricing Model. This model is used to determine the price of assets based on their risk. Time, uncertainty, options, and information are variables that decisions are based off of in financial economics, demonstrated by an asset’s risk being a variable in determining its value.
Financial economics is different from regular economics because it emphasizes the impact individual investments have on financial markets. Financial economists see prices and rates as being the outcomes of the choices to buy or sell that investors make. By using factors that alter investment decisions, financial economists predict the behaviour of financial markets. Market conditions can be predicted using financial economic theories and equations.
Arbitrage, the process of making money through trade without the risk of losing money, is an important concept in financial economics. It relates to profit maximization and is used in parts of financial theory.
As a quantitative discipline, financial economics uses econometrics and other mathematical processes in its theory development and practices.