Financial economics

Financial economics treats the financial system as an open interactive system dealing both in claims upon future goods and services, and in the allocation of the risks that are associated with such claims. It is concerned with the investment choices made by individuals, with the financing choices made by corporations, with the conduct of financial organisations that act as financial intermediaries between individuals and corporations; and with the effects of it all upon the economy.

(See the related articles subpage for definitions of the terms shown in italics in this article)

Financial systems

Common features

The essential functions of a financial system are taken to be to connect prospective investors with investment opportunities, and to allocate risk in accordance with the preferences of prospective risk-takers. Its components are taken be corporations, investors, financial intermediaries and a financial regulator; its instruments are taken to include a variety of types of shareholding, debt instruments and options that are traded, together with financial derivatives, in a variety of financial markets; and its activities are taken to be governed by rules and practices administered by regulatory authorities.

The financial activities of governments are the subject of a separate article on public finance, and investment choices within corporations are the subject of a separate article on business economics.

Effects on economic performance

The evidence strongly suggests that a well-developed financial system is good for economic growth, and although comparisons between systems in which companies raise finance mainly by borrowing from the banks (as in Germany and Japan) with "equity-based systems" in which companies raise it mainly by issuing shares (as in the United States and Britain) have been inconclusive, they suggest that equity-based systems are better at promoting hi-tech growth. . Equity-based systems promote economic activity by enabling prospective investors to finance capital investment by purchasing shares offered by corporations. The incentive to do so is increased by a facility to dispose of them at will in financial markets, and that incentive is further increased by the availability of financial derivatives that help the prospective investor to chose his preferred combination of risk and return.

The investment choices facing individuals

The efficient markets hypothesis

Long before economic analysis was applied to the problem, investment advisors had been advising their clients about their stock market investments, and fund managers had been taking decisions on their behalf. Some sought to predict future movements of the price of a share from a study of the pattern of its recent price movements (known as “technical analysis”) and some attempted to do so by examining the issuing company’s competitive position and the factors affecting the markets in which it operates (known as "fundamental analysis"). But in 1933, an economist suggested that both might be wasting their time. Applying the concept of a "perfect market" to the stock exchange, the economist Alfred Cowles asked the question "Can Stock Market Forecasters Forecast?" in a 1933 article and gave his answer as "it is doubtful", thereby starting a controversy that has yet to be fully resolved. Cowles argued that in an "efficient market" all of the information upon which a forecast could be based was already embodied in the price of the share in question. The question whether stock markets do operate as efficient markets was subsequently explored in studies undertaken and summarised by the economist Eugene Fama