Financial Economics

Financial economicsis a branch ofeconomicsthat analyzes the distribution and use of resources in markets in which decisions are made under uncertainty. Financialdecisions must often take into account future events, whether those are related to individual stocks, portfolios or the market as a whole. The subject is concerned with the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment. It, therefore, centres on decision-making under uncertainty in the context of financial markets. It is built on the foundations of microeconomics and decision theory. Financial economics is important in making investment decisions, identifying risks, and valuing securities and assets. It relies heavily on microeconomics and basic accounting concepts. In addition, it requires familiarity with basic statistics and probability since these are the standard tools used to measure and evaluate risk. Financial economics employs economic theory to evaluate how time, risk, opportunity costs and information can create incentives or disincentives for a particular decision. Financial economics often involves the creation of sophisticated models to test variables affecting a particular decision. Often, these models assume that individuals or institutions making decisions act rationally, though this is not necessarily the case. Irrational behaviour of parties has to be taken into account in financial economics as a potential risk factor. This book provides a comprehensive description of the theory and functioning of financial economics (or economics of finance). It is spread over 28 chapters which have been organized into 5 theme parts. Part I (chapters 1 and 2) is titled Basics of Financial Economics. It gives a birds eye view of financial system, financial economics, financial institutions, financial markets and financial instruments. Part II (chapters 3 to 10) is titled Investment Theory and Portfolio Analysis. It deals with discussion on theory of the rate of interest, reasons for interest rate differentials, term structure of interest rates and yield curves, portfolio of assets, mean-variance portfolio analysis, Markowitz model, capital asset pricing model (CAPM), capital market line (CML) and security market line (SML). Part III (chapters 11 to 17) is titled Derivatives, Forwards, Futures and Options. It covers emergence and popularity of financial derivatives, forward contracts, future contracts, options, Black-Scholes-Merton option pricing model, binomial option pricing model, and principles of arbitrage. Part IV (chapters 18 to 22) is titled Corporate Finance. It focuses on the patterns of corporate financing, capital structure and the cost of capital, corporate debt, dividend policy models, and Modigliani-Miller theorem. Part V (chapters 23 to 28) is titled Indian Financial System. It delves into financial institutions, financial markets, financial instruments, financial inclusion, financial regulators, and legislative and institutional measures to strengthen financial sector in India.