Financial economics

Financial economics is the branch of economics characterized by a "concentration on monetary activities",

in which "money of one type or another is likely to appear on both sides of a trade".[1] Its concern is thus
the interrelation of financial variables, such as share prices, interest rates and exchange rates, as opposed to
those concerning the real economy. It has two main areas of focus:[2] asset pricing and corporate finance;
the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. It thus
provides the theoretical underpinning for much of finance.

The subject is concerned with "the allocation and deployment of economic resources, both spatially and
across time, in an uncertain environment".[3][4] It therefore centers on decision making under uncertainty in
the context of the financial markets, and the resultant economic and financial models and principles, and is
concerned with deriving testable or policy implications from acceptable assumptions. It thus also includes a
formal study of the financial markets themselves, especially market microstructure and market regulation. It
is built on the foundations of microeconomics and decision theory.

Financial econometrics is the branch of financial economics that uses econometric techniques to
parameterise the relationships identified. Mathematical finance is related in that it will derive and extend the
mathematical or numerical models suggested by financial economics. Whereas financial economics has a
primarily microeconomic focus, monetary economics is primarily macroeconomic in nature.

Underlying economics
Financial economics studies how rational investors would apply Fundamental valuation equation [5]
decision theory to investment management. The subject is thus
built on the foundations of microeconomics and derives several
key results for the application of decision making under
uncertainty to the financial markets. The underlying economic
logic yields the fundamental theorem of asset pricing, which gives
the conditions for arbitrage-free asset pricing.[6][5] The aside
formulae result directly.

Four equivalent formulations,[6]

Present value, expectation and utility where:

is the asset or security

Underlying all of financial economics are the concepts of present
are the various states
value and expectation.[6] is the risk-free return
dollar payoffs in each state
Calculating their present value allows the decision maker a subjective, personal probability
assigned to the state;
to aggregate the cashflows (or other returns) to be produced by the
asset in the future to a single value at the date in question, and to risk aversion factors by state,
thus more readily compare two opportunities; this concept is the normalized s.t.
starting point for financial decision making. [note 1] , risk neutral probabilities
the stochastic discount
An immediate extension is to combine probabilities with present factor
value, leading to the expected value criterion which sets asset state prices;
value as a function of the sizes of the expected payouts and the
probabilities of their occurrence, and respectively. [note 2]
This decision method, however, fails to consider risk aversion ("as any student of finance knows"[6]). In
other words, since individuals receive greater utility from an extra dollar when they are poor and less utility
when comparatively rich, the approach is to therefore "adjust" the weight assigned to the various outcomes
("states") correspondingly, . See indifference price. (Some investors may in fact be risk seeking as
opposed to risk averse, but the same logic would apply).

Choice under uncertainty here may then be characterized as the maximization of expected utility. More
formally, the resulting expected utility hypothesis states that, if certain axioms are satisfied, the subjective
value associated with a gamble by an individual is that individual's statistical expectation of the valuations
of the outcomes of that gamble.

The impetus for these ideas arise from various inconsistencies observed under the expected value
framework, such as the St. Petersburg paradox and the Ellsberg paradox. [note 3]

Arbitrage-free pricing and equilibrium

The concepts of arbitrage-free, "rational", pricing and equilibrium are then coupled with the above to derive
"classical"[11] (or "neo-classical"[12]) financial economics.

Rational pricing is the assumption that asset prices (and hence asset pricing models) will reflect the
arbitrage-free price of the asset, as any deviation from this price will be "arbitraged away". This assumption
is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of
derivative instruments.

Economic equilibrium is, in general, a state in which economic forces such as supply and demand are
balanced, and, in the absence of external influences these equilibrium values of economic variables will not
change. General equilibrium deals with the behavior of supply, demand, and prices in a whole economy
with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an
overall equilibrium. (This is in contrast to partial equilibrium, which only analyzes single markets.)

The two concepts are linked as follows: where market prices do not allow for profitable arbitrage, i.e. they
comprise an arbitrage-free market, then these prices are also said to constitute an "arbitrage equilibrium".
Intuitively, this may be seen by considering that where an arbitrage opportunity does exist, then prices can
be expected to change, and are therefore not in equilibrium.[13] An arbitrage equilibrium is thus a
precondition for a general economic equilibrium.

The immediate, and formal, extension of this idea, the fundamental theorem of asset pricing, shows that
where markets are as described – and are additionally (implicitly and correspondingly) complete – one may
then make financial decisions by constructing a risk neutral probability measure corresponding to the
market.

"Complete" here means that there is a price for every asset in every possible state of the world, , and that
the complete set of possible bets on future states-of-the-world can therefore be constructed with existing
assets (assuming no friction): essentially solving simultaneously for n (risk-neutral) probabilities, , given n
prices. For a simplified example see Rational pricing § Risk neutral valuation, where the economy has only
two possible states – up and down – and where and (= ) are the two corresponding
probabilities, and in turn, the derived distribution, or "measure".

The formal derivation will proceed by arbitrage arguments.[6][13] The analysis here is often undertaken
assuming a representative agent, [14] essentially treating all market-participants, "agents", as identical (or, at
least, that they act in such a way that the sum of their choices is equivalent to the decision of one individual)
with the effect that the problems are then mathematically tractable.
With this measure in place, the expected, i.e. required, return of JEL classification codes
any security (or portfolio) will then equal the riskless return, plus
In the Journal of Economic Literature
an "adjustment for risk",[6] i.e. a security-specific risk premium, classification codes, Financial
compensating for the extent to which its cashflows are Economics is one of the 19 primary
unpredictable. All pricing models are then essentially variants of classifications, at JEL: G. It follows
Monetary and International Economics
this, given specific assumptions or conditions.[6][5][15] This and precedes Public Economics. For
approach is consistent with the above, but with the expectation detailed subclassifications see JEL
based on "the market" (i.e. arbitrage-free, and, per the theorem, classification codes § G. Financial
therefore in equilibrium) as opposed to individual preferences. Economics.

The New Palgrave Dictionary of

Thus, continuing the example, in pricing a derivative instrument its
forecasted cashflows in the up- and down-states, and Economics (2008, 2nd ed.) also
,
uses the JEL codes to classify its
are multiplied through by and , and are then discounted
entries in v. 8, Subject Index,
at the risk-free interest rate; per the second equation above. In including Financial Economics
pricing a "fundamental", underlying, instrument (in equilibrium), at pp.  863–64. The below have
on the other hand, a risk-appropriate premium over risk-free is links to entry abstracts of The
required in the discounting, essentially employing the first New Palgrave Online (https://we
equation with and combined. In general, this premium may be b.archive.org/web/20130210185
derived by the CAPM (or extensions) as will be seen under 054/http://www.dictionaryofecon
§ Uncertainty. omics.com/dictionary) for each
primary or secondary JEL
The difference is explained as follows: By construction, the value category (10 or fewer per page,
of the derivative will (must) grow at the risk free rate, and, by
similar to Google searches):
arbitrage arguments, its value must then be discounted
correspondingly; in the case of an option, this is achieved by JEL: G (http://www.dictionaryofe
"manufacturing" the instrument as a combination of the underlying conomics.com/search_results?,q
and a risk free "bond"; see Rational pricing § Delta hedging (and =&field=content&edition=all&topi
cid=G) – Financial Economics
§ Uncertainty below). Where the underlying is itself being priced, JEL: G0 (http://www.dictionaryof
such "manufacturing" is of course not possible – the instrument economics.com/search_results?
being "fundamental", i.e. as opposed to "derivative" – and a q=&field=content&edition=all&to
picid=G0) – General
premium is then required for risk.
JEL: G1 (http://www.dictionaryof
economics.com/search_results?
(Correspondingly, mathematical finance separates into two q=&field=content&edition=all&to
analytic regimes: risk and portfolio management (generally) use picid=G1) – General Financial
physical (or actual or actuarial) probability, denoted by "P"; while Markets
JEL: G2 (http://www.dictionaryof
derivatives pricing uses risk-neutral probability (or arbitrage- economics.com/search_results?
pricing probability), denoted by "Q". In specific applications the q=&field=content&edition=all&to
lower case is used, as in the above equations.) picid=G2) – Financial institutions
and Services
JEL: G3 (http://www.dictionaryof
economics.com/search_results?
State prices q=&field=content&edition=all&to
picid=G3) – Corporate finance
With the above relationship established, the further specialized and Governance
Arrow–Debreu model may be derived. [note 4] This result suggests
Tertiary category entries can
that, under certain economic conditions, there must be a set of
also be searched.[10]
prices such that aggregate supplies will equal aggregate demands
for every commodity in the economy. The Arrow–Debreu model
applies to economies with maximally complete markets, in which there exists a market for every time
period and forward prices for every commodity at all time periods.
A direct extension, then, is the concept of a state price security (also called an Arrow–Debreu security), a
contract that agrees to pay one unit of a numeraire (a currency or a commodity) if a particular state occurs
("up" and "down" in the simplified example above) at a particular time in the future and pays zero
numeraire in all the other states. The price of this security is the state price of this particular state of the
world; also referred to as a "Risk Neutral Density". [19]

In the above example, the state prices, , would equate to the present values of and :
i.e. what one would pay today, respectively, for the up- and down-state securities; the state price vector is
the vector of state prices for all states. Applied to derivative valuation, the price today would simply be [
× + × ]: the fourth formula (see above regarding the absence of a risk premium here). For
a continuous random variable indicating a continuum of possible states, the value is found by integrating
over the state price "density". These concepts are extended to martingale pricing and the related risk-neutral
measure.

State prices find immediate application as a conceptual tool ("contingent claim analysis");[6] but can also be
applied to valuation problems.[20] Given the pricing mechanism described, one can decompose the
derivative value – true in fact for "every security"[2] – as a linear combination of its state-prices; i.e. back-
solve for the state-prices corresponding to observed derivative prices.[21][20] [19] These recovered state-
prices can then be used for valuation of other instruments with exposure to the underlyer, or for other
decision making relating to the underlyer itself.

Using the related stochastic discount factor - also called the pricing kernel - the asset price is computed by
"discounting" the future cash flow by the stochastic factor , and then taking the expectation;[15] the third
equation above. Essentially, this factor divides expected utility at the relevant future period - a function of
the possible asset values realized under each state - by the utility due to today's wealth, and is then also
referred to as "the intertemporal marginal rate of substitution".

Resultant models
Applying the above economic concepts, we may then derive
various economic- and financial models and principles. As
above, the two usual areas of focus are Asset Pricing and
Corporate Finance, the first being the perspective of providers
DCF valuation formula, where the
of capital, the second of users of capital. Here, and for (almost)
value of the firm, is its forecasted free
all other financial economics models, the questions addressed
cash flows discounted to the present
are typically framed in terms of "time, uncertainty, options, and
using the weighted average cost of
information",[1][14] as will be seen below.
capital. For share valuation investors
Time: money now is traded for money in the future. use the related dividend discount
model.
Uncertainty (or risk): The amount of money to be
transferred in the future is uncertain.
Options: one party to the transaction can make a decision at a later time that will affect
subsequent transfers of money.
Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty
associated with future monetary value (FMV).
Applying this framework, with the above concepts, leads to the
required models. This derivation begins with the assumption of "no
uncertainty" and is then expanded to incorporate the other
considerations.[4] (This division sometimes denoted "deterministic"
and "random",[22] or "stochastic".)

Certainty

The starting point here is "Investment under certainty", and usually Modigliani–Miller Proposition II with
framed in the context of a corporation. The Fisher separation
risky debt. Even if leverage (D/E)
theorem, asserts that the objective of the corporation will be the increases, the WACC (k0) stays
maximization of its present value, regardless of the preferences of constant.
its shareholders. Related is the Modigliani–Miller theorem, which
shows that, under certain conditions, the value of a firm is
unaffected by how that firm is financed, and depends neither on its
dividend policy nor its decision to raise capital by issuing stock or
selling debt. The proof here proceeds using arbitrage arguments,
and acts as a benchmark for evaluating the effects of factors outside
the model that do affect value. [note 5]

The mechanism for determining (corporate) value is provided by

[25] [26] John Burr Williams' The Theory of Investment Value, which Efficient Frontier. The hyperbola is
proposes that the value of an asset should be calculated using sometimes referred to as the
"evaluation by the rule of present worth". Thus, for a common 'Markowitz Bullet', and its upward
sloped portion is the efficient frontier
stock, the "intrinsic", long-term worth is the present value of its
if no risk-free asset is available.
future net cashflows, in the form of dividends. What remains to be
With a risk-free asset, the straight
determined is the appropriate discount rate. Later developments
line is the efficient frontier. The
show that, "rationally", i.e. in the formal sense, the appropriate
graphic displays the CAL, Capital
discount rate here will (should) depend on the asset's riskiness
allocation line, formed when the
relative to the overall market, as opposed to its owners' preferences;
risky asset is a single-asset rather
see below. Net present value (NPV) is the direct extension of these
than the market, in which case the
ideas typically applied to Corporate Finance decisioning. For other
line is the CML.
results, as well as specific models developed here, see the list of
"Equity valuation" topics under Outline of finance §  Discounted
cash flow valuation. [note 6]

Bond valuation, in that cashflows (coupons and return of principal) are deterministic, may proceed in the
same fashion.[22] An immediate extension, Arbitrage-free bond pricing, discounts each cashflow at the
market derived rate – i.e. at each coupon's corresponding zero-rate – as opposed to an overall rate. In many
treatments bond valuation precedes equity valuation, under which cashflows (dividends) are not "known"
per se. Williams and onward allow for forecasting as to these – based on historic ratios or published policy
– and cashflows are then treated as essentially deterministic; see below under § Corporate finance theory.

These "certainty" results are all commonly employed under corporate finance; uncertainty is the focus of
"asset pricing models", as follows. Fisher's formulation of the theory here - developing an intertemporal
equilibrium model - underpins also [25] the below applications to uncertainty. [note 7] See [27] for the
development.

Uncertainty
For "choice under uncertainty" the twin assumptions of rationality
and market efficiency, as more closely defined, lead to modern
portfolio theory (MPT) with its capital asset pricing model (CAPM)
– an equilibrium-based result – and to the Black–Scholes–Merton
theory (BSM; often, simply Black–Scholes) for option pricing – an
arbitrage-free result. As above, the (intuitive) link between these, is
that the latter derivative prices are calculated such that they are
arbitrage-free with respect to the more fundamental, equilibrium
determined, securities prices; see Asset pricing § Interrelationship.

Briefly, and intuitively – and consistent with §  Arbitrage-free The Capital market line is the
pricing and equilibrium above – the relationship between rationality tangent line drawn from the point of
and efficiency is as follows.[28] Given the ability to profit from the risk-free asset to the feasible
private information, self-interested traders are motivated to acquire region for risky assets. The
and act on their private information. In doing so, traders contribute tangency point M represents the
to more and more "correct", i.e. efficient, prices: the efficient-market market portfolio. The CML results
hypothesis, or EMH. Thus, if prices of financial assets are (broadly) from the combination of the market
efficient, then deviations from these (equilibrium) values could not portfolio and the risk-free asset (the
last for long. (See earnings response coefficient.) The EMH point L). Addition of leverage (the
(implicitly) assumes that average expectations constitute an "optimal point R) creates levered portfolios
forecast", i.e. prices using all available information are identical to that are also on the CML.
the best guess of the future: the assumption of rational expectations.
The EMH does allow that when faced with new information, The capital asset pricing model (CAPM):
some investors may overreact and some may underreact, but what
is required, however, is that investors' reactions follow a normal
distribution – so that the net effect on market prices cannot be
The expected return used when
reliably exploited to make an abnormal profit. In the competitive
discounting cashflows on an asset ,
limit, then, market prices will reflect all available information and
is the risk-free rate plus the market
prices can only move in response to news:[29] the random walk
premium multiplied by beta (
hypothesis. This news, of course, could be "good" or "bad",
minor or, less common, major; and these moves are then, ), the asset's correlated volatility
correspondingly, normally distributed; with the price therefore relative to the overall market .
following a log-normal distribution. [note 8]

Under these conditions, investors can then be assumed to act

rationally: their investment decision must be calculated or a loss is
sure to follow; correspondingly, where an arbitrage opportunity
presents itself, then arbitrageurs will exploit it, reinforcing this
equilibrium. Here, as under the certainty-case above, the specific
assumption as to pricing is that prices are calculated as the present
value of expected future dividends, [5] [29] [14] as based on
currently available information. What is required though, is a theory
for determining the appropriate discount rate, i.e. "required return",
given this uncertainty: this is provided by the MPT and its CAPM.
Security market line: the
Relatedly, rationality – in the sense of arbitrage-exploitation – gives
representation of the CAPM
rise to Black–Scholes; option values here ultimately consistent with
displaying the expected rate of
the CAPM.
return of an individual security as a
In general, then, while portfolio theory studies how investors should function of its systematic, non-
diversifiable risk.
balance risk and return when investing in many assets or securities,
the CAPM is more focused, describing how, in equilibrium,
markets set the prices of assets in relation to how risky they are.
[note 9] This result will be independent of the investor's level of risk
aversion and assumed utility function, thus providing a readily
determined discount rate for corporate finance decision makers as
above,[31] and for other investors. The argument proceeds as
follows: If one can construct an efficient frontier – i.e. each
combination of assets offering the best possible expected level of
return for its level of risk, see diagram – then mean-variance
efficient portfolios can be formed simply as a combination of
holdings of the risk-free asset and the "market portfolio" (the
Mutual fund separation theorem), with the combinations here Simulated geometric Brownian
plotting as the capital market line, or CML. Then, given this CML, motions with parameters from
the required return on a risky security will be independent of the market data
investor's utility function, and solely determined by its covariance
("beta") with aggregate, i.e. market, risk. This is because investors
The Black–Scholes equation:
here can then maximize utility through leverage as opposed to
pricing; see Separation property (finance), Markowitz model
§ Choosing the best portfolio and CML diagram aside. As can be
seen in the formula aside, this result is consistent with the Interpretation: by arbitrage arguments, the
preceding, equaling the riskless return plus an adjustment for instantaneous impact of time and change in
spot price on an option price will (must)
risk.[5] A more modern, direct, derivation is as described at the realize as growth at , the risk free rate, when
the option is correctly "manufactured" (i.e.
bottom of this section; which can be generalized to derive other hedged).
equilibrium-pricing models.
The Black–Scholes formula for the value of a call option:
Black–Scholes provides a mathematical model of a
financial market containing derivative instruments,
and the resultant formula for the price of European-
styled options. [note 10] The model is expressed as the
Black–Scholes equation, a partial differential equation Interpretation: The value of a call is the risk free rated present
describing the changing price of the option over time; value of its expected in the money value (i.e. a specific
formulation of the fundamental valuation result). is the
it is derived assuming log-normal, geometric probability that the call will be exercised; is the present
Brownian motion (see Brownian model of financial value of the expected asset price at expiration, given that the
asset price at expiration is above the exercise price.
markets). The key financial insight behind the model
is that one can perfectly hedge the option by buying
and selling the underlying asset in just the right way and consequently "eliminate risk", absenting the risk
adjustment from the pricing ( , the value, or price, of the option, grows at , the risk-free rate).[6][5] This
hedge, in turn, implies that there is only one right price – in an arbitrage-free sense – for the option. And
this price is returned by the Black–Scholes option pricing formula. (The formula, and hence the price, is
consistent with the equation, as the formula is the solution to the equation.) Since the formula is without
reference to the share's expected return, Black–Scholes inheres risk neutrality; intuitively consistent with the
"elimination of risk" here, and mathematically consistent with §  Arbitrage-free pricing and equilibrium
above. Relatedly, therefore, the pricing formula may also be derived directly via risk neutral expectation.
Itô's lemma provides the underlying mathematics, and, with Itô calculus more generally, remains
fundamental in quantitative finance. [note 11]

As mentioned, it can be shown that the two models are consistent; then, as is to be expected, "classical"
financial economics is thus unified. Here, the Black Scholes equation can alternatively be derived from the
CAPM, and the price obtained from the Black–Scholes model is thus consistent with the assumptions of the
CAPM.[37][12] The Black–Scholes theory, although built on Arbitrage-free pricing, is therefore consistent
with the equilibrium based capital asset pricing. Both models, in turn, are ultimately consistent with the
Arrow–Debreu theory, and can be derived via state-pricing – essentially, by expanding the fundamental
result above – further explaining, and if required demonstrating, this unity.[6] Here, the CAPM is derived
by linking , risk aversion, to overall market return, and setting the return on security as ; see
Stochastic discount factor §  Properties. The Black-Scholes formula is found, in the limit, by attaching a
binomial probability to each of numerous possible spot-prices (states) and then rearranging for the terms
corresponding to and , per the boxed description; see Binomial options pricing model
§ Relationship with Black–Scholes.

Extensions
More recent work further generalizes and extends these models. As regards asset pricing, developments in
equilibrium-based pricing are discussed under "Portfolio theory" below, while "Derivative pricing" relates
to risk-neutral, i.e. arbitrage-free, pricing. As regards the use of capital, "Corporate finance theory" relates,
mainly, to the application of these models.

Portfolio theory

The majority of developments here relate to required return, i.e.

pricing, extending the basic CAPM. Multi-factor models such as the
Fama–French three-factor model and the Carhart four-factor model,
propose factors other than market return as relevant in pricing. The
intertemporal CAPM and consumption-based CAPM similarly extend
the model. With intertemporal portfolio choice, the investor now
repeatedly optimizes her portfolio; while the inclusion of consumption
(in the economic sense) then incorporates all sources of wealth, and not Plot of two criteria when
just market-based investments, into the investor's calculation of maximizing return and minimizing
required return. risk in financial portfolios (Pareto-
optimal points in red)
Whereas the above extend the CAPM, the single-index model is a
more simple model. It assumes, only, a correlation between security
and market returns, without (numerous) other economic
assumptions. It is useful in that it simplifies the estimation of
correlation between securities, significantly reducing the inputs for
building the correlation matrix required for portfolio optimization.
The arbitrage pricing theory (APT) similarly differs as regards its
assumptions. APT "gives up the notion that there is one right
portfolio for everyone in the world, and ...replaces it with an
explanatory model of what drives asset returns."[38] It returns the
required (expected) return of a financial asset as a linear function of
various macro-economic factors, and assumes that arbitrage should
bring incorrectly priced assets back into line.[note 12]
Examples of bivariate copulæ used
As regards portfolio optimization, the Black–Litterman model in finance.
departs from the original Markowitz model – i.e. of constructing
portfolios via an efficient frontier. Black–Litterman instead starts
with an equilibrium assumption, and is then modified to take into account the 'views' (i.e., the specific
opinions about asset returns) of the investor in question to arrive at a bespoke asset allocation. Where
factors additional to volatility are considered (kurtosis, skew...) then multiple-criteria decision analysis can
be applied; here deriving a Pareto efficient portfolio. The universal portfolio algorithm applies machine
learning to asset selection, learning adaptively from historical data. Behavioral portfolio theory recognizes
that investors have varied aims and create an investment portfolio that meets a broad range of goals.
Copulas have lately been applied here; recently this is the case also for genetic algorithms and Machine
learning, more generally. (Tail) risk parity focuses on allocation of risk, rather than allocation of capital.
[note 13] See
Portfolio optimization § Improving portfolio optimization for other techniques and objectives,
and Financial risk management § Investment management for discussion.

Derivative pricing

In pricing derivatives, the binomial options pricing model provides

a discretized version of Black–Scholes, useful for the valuation of
American styled options. Discretized models of this type are built –
at least implicitly – using state-prices (as above); relatedly, a large
number of researchers have used options to extract state-prices for a
variety of other applications in financial economics.[6][37][21] For
path dependent derivatives, Monte Carlo methods for option pricing
Binomial Lattice with CRR formulae
are employed; here the modelling is in continuous time, but
similarly uses risk neutral expected value. Various
other numeric techniques have also been developed. PDE for a zero-coupon bond:
The theoretical framework too has been extended
such that martingale pricing is now the standard
approach. [note 14]
Interpretation: Analogous to Black-Scholes, [41]
Drawing on these techniques, models for various arbitrage arguments describe the instantaneous
other underlyings and applications have also been change in the bond price for changes in the
developed, all based on the same logic (using (risk-free) short rate ; the analyst selects the
"contingent claim analysis"). Real options valuation specific short-rate model to be employed.
allows that option holders can influence the option's
underlying; models for employee stock option
valuation explicitly assume non-rationality on the part of option
holders; Credit derivatives allow that payment obligations or
delivery requirements might not be honored. Exotic derivatives are
now routinely valued. Multi-asset underlyers are handled via
simulation or copula based analysis.

Similarly, the various short-rate models allow for an extension of

these techniques to fixed income- and interest rate derivatives. (The
Vasicek and CIR models are equilibrium-based, while Ho–Lee and
subsequent models are based on arbitrage-free pricing.) The more
general HJM Framework describes the dynamics of the full
forward-rate curve – as opposed to working with short rates – and
is then more widely applied. The valuation of the underlying Stylized volatility smile: showing the
instrument – additional to its derivatives – is relatedly extended, (implied) volatility by strike-price, for
particularly for hybrid securities, where credit risk is combined with which the Black-Scholes formula
uncertainty re future rates; see Bond valuation § Stochastic calculus returns market prices.
approach and Lattice model (finance) § Hybrid securities. [note 15]

Following the Crash of 1987, equity options traded in American markets began to exhibit what is known as
a "volatility smile"; that is, for a given expiration, options whose strike price differs substantially from the
underlying asset's price command higher prices, and thus implied volatilities, than what is suggested by
BSM. (The pattern differs across various markets.) Modelling the volatility smile is an active area of
research, and developments here – as well as implications re the standard theory – are discussed in the next
section.
After the financial crisis of 2007–2008, a further development:[50] (over the counter) derivative pricing had
relied on the BSM risk neutral pricing framework, under the assumptions of funding at the risk free rate and
the ability to perfectly replicate cashflows so as to fully hedge. This, in turn, is built on the assumption of a
credit-risk-free environment – called into question during the crisis. Addressing this, therefore, issues such
as counterparty credit risk, funding costs and costs of capital are now additionally considered when
pricing,[51] and a credit valuation adjustment, or CVA – and potentially other valuation adjustments,
collectively xVA – is generally added to the risk-neutral derivative value.

A related, and perhaps more fundamental change, is that discounting is now on the Overnight Index Swap
(OIS) curve, as opposed to LIBOR as used previously.[50] This is because post-crisis, the overnight rate is
considered a better proxy for the "risk-free rate".[52] (Also, practically, the interest paid on cash collateral is
usually the overnight rate; OIS discounting is then, sometimes, referred to as "CSA discounting".) Swap
pricing – and, therefore, yield curve construction – is further modified: previously, swaps were valued off a
single "self discounting" interest rate curve; whereas post crisis, to accommodate OIS discounting,
valuation is now under a "multi-curve framework" where "forecast curves" are constructed for each
floating-leg LIBOR tenor, with discounting on the common OIS curve.

Corporate finance theory

Corporate finance theory has also been extended: mirroring the

above developments, asset-valuation and decisioning no longer
need assume "certainty". Monte Carlo methods in finance allow
financial analysts to construct "stochastic" or probabilistic corporate
finance models, as opposed to the traditional static and deterministic
models;[53] see Corporate finance §  Quantifying uncertainty.
Relatedly, Real Options theory allows for owner – i.e. managerial –
actions that impact underlying value: by incorporating option
pricing logic, these actions are then applied to a distribution of
future outcomes, changing with time, which then determine the
"project's" valuation today.[54] [note 16]

More traditionally, decision trees – which are complementary –

have been used to evaluate projects, by incorporating in the Project valuation via decision tree.
valuation (all) possible events (or states) and consequent
management decisions;[55][53] the correct discount rate here
reflecting each decision-point's "non-diversifiable risk looking forward."[53] [note 17]

Related to this, is the treatment of forecasted cashflows in equity valuation. In many cases, following
Williams above, the average (or most likely) cash-flows were discounted,[57] as opposed to a more correct
state-by-state treatment under uncertainty; see comments under Financial modeling § Accounting. In more
modern treatments, then, it is the expected cashflows (in the mathematical sense: ) combined into

an overall value per forecast period which are discounted. [58] [59] [60] [53] And using the CAPM – or
extensions – the discounting here is at the risk-free rate plus a premium linked to the uncertainty of the
entity or project cash flows [53] (essentially, and combined).

Other developments here include[61] agency theory, which analyses the difficulties in motivating corporate
management (the "agent") to act in the best interests of shareholders (the "principal"), rather than in their
own interests; here emphasizing the issues interrelated with capital structure. [62] Clean surplus accounting
and the related residual income valuation provide a model that returns price as a function of earnings,
expected returns, and change in book value, as opposed to dividends. This approach, to some extent, arises
due to the implicit contradiction of seeing value as a function of dividends, while also holding that dividend
policy cannot influence value per Modigliani and Miller's "Irrelevance principle"; see Dividend policy
§ Irrelevance of dividend policy.

"Corporate finance" as a discipline more generally, per Fisher above, relates to the long term objective of
maximizing the value of the firm - and its return to shareholders - and thus also incorporates the areas of
capital structure and dividend policy. [63] Extensions of the theory here then also consider these latter, as
follows: (i) optimization re capitalization structure, and theories here as to corporate choices and behavior:
Capital structure substitution theory, Pecking order theory, Market timing hypothesis, Trade-off theory; (ii)
considerations and analysis re dividend policy, additional to - and sometimes contrasting with - Modigliani-
Miller, include: the Walter model, Lintner model, and Residuals theory, as well as discussion re the
observed clientele effect and dividend puzzle.

As described, the typical application of real options is to capital budgeting type problems. However, here,
they are also applied to problems of capital structure and dividend policy, and to the related design of
corporate securities; [64] and since stockholder and bondholders have different objective functions, in the
analysis of the related agency problems. [54] In all of these cases, state-prices can provide the market-
implied information relating to the corporate, as above, which is then applied to the analysis. For example,
convertible bonds can (must) be priced consistent with the (recovered) state-prices of the corporate's
equity.[20][58]

Financial markets

The discipline, as outlined, also includes a formal study of financial markets. Of interest especially are
Market regulation and market microstructure, and their relationship to price efficiency.

Regulatory economics studies, in general, the economics of regulation. In the context of finance, it will
address the impact of Financial regulation on the functioning of markets and the efficiency of prices, while
also weighing the corresponding increases in market confidence and financial stability. Research here
considers how, and to what extent, regulations relating to disclosure (earnings guidance, annual reports),
insider trading, and short-selling will impact price efficiency, the cost of equity, and market liquidity.[65]

Market microstructure is concerned with the details of how exchange occurs in markets (with Walrasian-,
matching-, Fisher-, and Arrow-Debreu markets as prototypes), and "analyzes how specific trading
mechanisms affect the price formation process",[66] examining the ways in which the processes of a market
affect determinants of transaction costs, prices, quotes, volume, and trading behavior. It has been used, for
example, in providing explanations for long-standing exchange rate puzzles,[67] and for the equity premium
puzzle.[68] In contrast to the above classical approach, models here explicitly allow for (testing the impact
of) market frictions and other imperfections; see also market design.

For both regulation and microstructure,[69] and generally,[70] agent-based models can be developed[71] to
examine any impact due to a change in structure or policy - or to make inferences re market dynamics - by
testing these in an artificial financial market, or AFM. [note 18] This approach, essentially simulated trade
between numerous agents, "typically uses artificial intelligence technologies [often genetic algorithms and
neural nets] to represent the adaptive behaviour of market participants".[71]
These 'bottom-up' models "start from first principals of agent behavior",[72] with participants modifying
their trading strategies having learned over time, and "are able to describe macro features [i.e. stylized facts]
emerging from a soup of individual interacting strategies".[72] Agent-based models depart further from the
classical approach — the representative agent, as outlined — in that they introduce heterogeneity into the
environment (thereby addressing, also, the aggregation problem).

Challenges and criticism

As above, there is a very close link between (i) the random walk hypothesis, with the associated belief that
price changes should follow a normal distribution, on the one hand, and (ii) market efficiency and rational
expectations, on the other. Wide departures from these are commonly observed, and there are thus,
respectively, two main sets of challenges.

Departures from normality

As discussed, the assumptions that market prices follow a random

walk and that asset returns are normally distributed are fundamental.
Empirical evidence, however, suggests that these assumptions may
not hold, and that in practice, traders, analysts and risk managers
frequently modify the "standard models" (see Kurtosis risk,
Skewness risk, Long tail, Model risk). In fact, Benoit Mandelbrot
had discovered already in the 1960s [73] that changes in financial
prices do not follow a normal distribution, the basis for much option
pricing theory, although this observation was slow to find its way
into mainstream financial economics. [74]
Implied volatility surface. The Z-axis
Financial models with long-tailed distributions and volatility represents implied volatility in
clustering have been introduced to overcome problems with the percent, and X and Y axes represent
realism of the above "classical" financial models; while jump the option delta, and the days to
diffusion models allow for (option) pricing incorporating "jumps" in maturity.
the spot price.[75] Risk managers, similarly, complement (or
substitute) the standard value at risk models with historical
simulations, mixture models, principal component analysis, extreme value theory, as well as models for
volatility clustering.[76] For further discussion see Fat-tailed distribution § Applications in economics, and
Value at risk §  Criticism. Portfolio managers, likewise, have modified their optimization criteria and
algorithms; see § Portfolio theory above.

Closely related is the volatility smile, where, as above, implied volatility – the volatility corresponding to
the BSM price – is observed to differ as a function of strike price (i.e. moneyness), true only if the price-
change distribution is non-normal, unlike that assumed by BSM. The term structure of volatility describes
how (implied) volatility differs for related options with different maturities. An implied volatility surface is
then a three-dimensional surface plot of volatility smile and term structure. These empirical phenomena
negate the assumption of constant volatility – and log-normality – upon which Black–Scholes is
built.[34][75] Within institutions, the function of Black-Scholes is now, largely, to communicate prices via
implied volatilities, much like bond prices are communicated via YTM; see Black–Scholes model §  The
volatility smile.

In consequence traders (and risk managers) now, instead, use "smile-consistent" models, firstly, when
valuing derivatives not directly mapped to the surface, facilitating the pricing of other, i.e. non-quoted,
strike/maturity combinations, or of non-European derivatives, and generally for hedging purposes. The two
main approaches are local volatility and stochastic volatility. The first returns the volatility which is "local"
to each spot-time point of the finite difference- or simulation-based valuation; i.e. as opposed to implied
volatility, which holds overall. In this way calculated prices – and numeric structures – are market-
consistent in an arbitrage-free sense. The second approach assumes that the volatility of the underlying
price is a stochastic process rather than a constant. Models here are first calibrated to observed prices, and
are then applied to the valuation or hedging in question; the most common are Heston, SABR and CEV.
This approach addresses certain problems identified with hedging under local volatility.[77]

Related to local volatility are the lattice-based implied-binomial and -trinomial trees – essentially a
discretization of the approach – which are similarly, but less commonly,[19] used for pricing; these are built
on state-prices recovered from the surface. Edgeworth binomial trees allow for a specified (i.e. non-
Gaussian) skew and kurtosis in the spot price; priced here, options with differing strikes will return differing
implied volatilities, and the tree can be calibrated to the smile as required.[78] Similarly purposed (and
derived) closed-form models were also developed. [79]

As discussed, additional to assuming log-normality in returns, "classical" BSM-type models also

(implicitly) assume the existence of a credit-risk-free environment, where one can perfectly replicate
cashflows so as to fully hedge, and then discount at "the" risk-free-rate. And therefore, post crisis, the
various x-value adjustments must be employed, effectively correcting the risk-neutral value for
counterparty- and funding-related risk. These xVA are additional to any smile or surface effect. This is
valid as the surface is built on price data relating to fully collateralized positions, and there is therefore no
"double counting" of credit risk (etc.) when appending xVA. (Were this not the case, then each
counterparty would have its own surface...)

As mentioned at top, mathematical finance (and particularly financial engineering) is more concerned with
mathematical consistency (and market realities) than compatibility with economic theory, and the above
"extreme event" approaches, smile-consistent modeling, and valuation adjustments should then be seen in
this light. Recognizing this, James Rickards, amongst other critics [74] of financial economics, suggests that,
instead, the theory needs revisiting almost entirely:

"The current system, based on the idea that risk is distributed in the shape of a bell curve,
is flawed... The problem is [that economists and practitioners] never abandon the bell
curve. They are like medieval astronomers who believe the sun revolves around the earth
and are furiously tweaking their geo-centric math in the face of contrary evidence. They
will never get this right; they need their Copernicus."[80]

Departures from rationality

As seen, a common assumption is that financial decision makers act rationally; see Homo economicus.
Recently, however, researchers in experimental economics and experimental finance have challenged this
assumption empirically. These assumptions are also challenged theoretically, by behavioral finance, a
discipline primarily concerned with the limits to rationality of economic agents. [note 19] For related
criticisms re corporate finance theory vs its practice see:.[81]

Consistent with, and complementary to these findings, various persistent market anomalies have been
documented, these being price or return distortions – e.g. size premiums – which appear to contradict the
efficient-market hypothesis; calendar effects are the best known group here. Related to these are various of
the economic puzzles, concerning phenomena similarly contradicting the theory. The equity premium
puzzle, as one example, arises in that the difference between the observed returns on stocks as compared to
government bonds is consistently higher than the risk premium rational Market anomalies and
equity investors should demand, an "abnormal return". For further context economic puzzles
see Random walk hypothesis § A non-random walk hypothesis, and
sidebar for specific instances. Calendar effect

January effect
More generally, and particularly following the financial crisis of 2007–
Sell in May
2008, financial economics and mathematical finance have been subjected
Mark Twain effect
to deeper criticism; notable here is Nassim Nicholas Taleb, who claims
Santa Claus rally
that the prices of financial assets cannot be characterized by the simple
Closed-end fund puzzle
models currently in use, rendering much of current practice at best
Dividend puzzle
irrelevant, and, at worst, dangerously misleading; see Black swan theory,
Equity home bias puzzle
Taleb distribution. A topic of general interest has thus been financial crises,
[82] and the failure of (financial) economics to model (and predict) these. Equity premium puzzle
Forward premium anomaly
Low-volatility anomaly
A related problem is systemic risk: where companies hold securities in
Momentum anomaly
each other then this interconnectedness may entail a "valuation chain" –
Neglected firm effect
and the performance of one company, or security, here will impact all, a
Post-earnings-
phenomenon not easily modeled, regardless of whether the individual
announcement drift
models are correct. See: Systemic risk § Inadequacy of classic valuation
Real exchange-rate
models; Cascades in financial networks; Flight-to-quality. puzzles

Areas of research attempting to explain (or at least model) these

phenomena, and crises, include[14] noise trading, market microstructure (as above), and Heterogeneous
agent models. The latter is extended to agent-based computational models, as mentioned; here [70] price is
treated as an emergent phenomenon, resulting from the interaction of the various market participants
(agents). The noisy market hypothesis argues that prices can be influenced by speculators and momentum
traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to
fundamental value; see Noise (economic). The adaptive market hypothesis is an attempt to reconcile the
efficient market hypothesis with behavioral economics, by applying the principles of evolution to financial
interactions. An information cascade, alternatively, shows market participants engaging in the same acts as
others ("herd behavior"), despite contradictions with their private information. Copula-based modelling has
similarly been applied. See also Hyman Minsky's "financial instability hypothesis", as well as George
Soros' application of "reflexivity".

On the obverse, however, various studies have shown that despite these departures from efficiency, asset
prices do typically exhibit a random walk and that one cannot therefore consistently outperform market
averages, i.e. attain "alpha".[83] The practical implication, therefore, is that passive investing (e.g. via low-
cost index funds) should, on average, serve better than any other active strategy.[84] [note 20] Relatedly,
institutionally inherent limits to arbitrage – as opposed to factors directly contradictory to the theory – are
sometimes proposed as an explanation for these departures from efficiency.

See also
Category:Finance theories
Category:Financial models
Deutsche Bank Prize in Financial Economics
Finance § Financial theory
Fischer Black Prize
List of financial economics articles
List of financial economists
List of unsolved problems in economics § Financial economics
 Master of Financial Economics
Monetary economics
Outline of economics
Outline of corporate finance
Outline of finance

Historical notes
1. Its history is correspondingly early: Fibonacci developed the concept of present value
already in 1202 in his Liber Abaci. Compound interest was discussed in depth by Richard
Witt in 1613, in his Arithmeticall Questions,[7] and was further developed by Johan de Witt in
1671 [8] and by Edmond Halley in 1705.[9]
2. These ideas originate with Blaise Pascal and Pierre de Fermat in 1654.
3. The development here is originally due to Daniel Bernoulli in 1738, which was later
formalized by John von Neumann and Oskar Morgenstern in 1947.
4. State prices originate with Kenneth Arrow and Gérard Debreu in 1954.[16] Lionel W.
McKenzie is also cited for his independent proof of equilibrium existence in 1954.[17]
Breeden and Litzenberger's work in 1978[18] established the use of state prices in financial
economics.
5. The theorem of Franco Modigliani and Merton Miller is often called the "capital structure
irrelevance principle"; it is presented in two key papers of 1958,[23] and 1963.[24]
6. John Burr Williams published his "Theory" in 1938; NPV was recommended to corporate
managers by Joel Dean in 1951.
7. In fact, "Fisher (1930, [The Theory of Interest]) is the seminal work for most of the financial
theory of investments during the twentieth century… Fisher develops the first formal
equilibrium model of an economy with both intertemporal exchange and production. In so
doing, at one swoop, he not only derives present value calculations as a natural economic
outcome in calculating wealth, he also justifies the maximization of present value as the goal
of production and derives determinants of the interest rates that are used to calculate present
value."[11]: 55 
8. The EMH was presented by Eugene Fama in a 1970 review paper,[30] consolidating
previous works re random walks in stock prices: Jules Regnault, 1863; Louis Bachelier,
1900; Maurice Kendall, 1953; Paul Cootner, 1964; and Paul Samuelson, 1965, among
others.
9. The efficient frontier was introduced by Harry Markowitz in 1952. The CAPM was derived by
Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965), and Jan Mossin
(1966) independently.
10. "BSM" – two seminal 1973 papers by Fischer Black and Myron Scholes,[32] and Robert C.
Merton[33] – is consistent with "previous versions of the formula" of Louis Bachelier (1900)
and Edward O. Thorp (1967);[34] although these were more "actuarial" in flavor, and had not
established risk-neutral discounting.[12] Vinzenz Bronzin (1908) produced very early results,
also.
11. Kiyosi Itô published his Lemma in 1944. Paul Samuelson[35] introduced this area of
mathematics into finance in 1965; Robert Merton promoted continuous stochastic calculus
and continuous-time processes from 1969. [36]
12. The single-index model was developed by William Sharpe in 1963. [39] APT was developed
by Stephen Ross in 1976. [40] The linear factor model structure of the APT is used as the
basis for many of the commercial risk systems employed by asset managers.
13. The universal portfolio algorithm was published by Thomas M. Cover in 1991. The Black–
Litterman model was developed in 1990 at Goldman Sachs by Fischer Black and Robert
Litterman, and published in 1992.
14. The binomial model was first proposed by William Sharpe in the 1978 edition of Investments
(ISBN 013504605X), and in 1979 formalized by Cox, Ross and Rubinstein [42] and by
Rendleman and Bartter. [43] Finite difference methods for option pricing were due to Eduardo
Schwartz in 1977.[44] Monte Carlo methods for option pricing were originated by Phelim
Boyle in 1977; [45] In 1996, methods were developed for American [46] and Asian options.
[47]

15. Oldrich Vasicek developed his pioneering short-rate model in 1977. [48] The HJM framework
originates from the work of David Heath, Robert A. Jarrow, and Andrew Morton in 1987. [49]
16. Simulation was first applied to (corporate) finance by David B. Hertz in 1964; Real options in
corporate finance were first discussed by Stewart Myers in 1977.
17. This technique predates the use of real options in corporate finance;[56] it is borrowed from
operations research, and is not a "financial economics development" per se.
18. The Benchmark here is the pioneering AFM of the Santa Fe Institute developed in the early
1990s. See [72] for discussion of other early models.
19. An early anecdotal treatment is Benjamin Graham's "Mr. Market", discussed in his The
Intelligent Investor in 1949. See also John Maynard Keynes' 1936 discussion of "Animal
spirits", and the related Keynesian beauty contest, in his General Theory, Ch. 12.
Extraordinary Popular Delusions and the Madness of Crowds is a study of crowd
psychology by Scottish journalist Charles Mackay, first published in 1841, with Volume I
discussing economic bubbles.
20. Burton Malkiel's A Random Walk Down Wall Street – first published in 1973, and in its 13th
edition as of 2023 – is a widely read popularization of these arguments. See also John C.
Bogle's Common Sense on Mutual Funds; but compare Warren Buffett's The Superinvestors
of Graham-and-Doddsville.

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External links

Surveys Course material Links and portals

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History of Finance: An Pricing (http://pages.st Guide (http://www.aeaweb.o
Eyewitness Account". Journal ern.nyu.edu/~dbackus/ rg/jel/guide/jel.php?class=
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13 (2): 8–14. pricing.pdf), David K. Financial Economics Links
doi:10.1111/j.1745- Backus, NYU, Stern on AEA's RFE (http://rfe.org/
6622.2000.tb00050.x (https://d Financial Economics: showCat.php?cat_id=56)
oi.org/10.1111%2Fj.1745-662 Classics and SSRN Financial Economics
2.2000.tb00050.x). Contemporary (http://a Network (http://www.ssrn.co
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e.doc), II (https://web.archive.or omele.org/financial_ec
k.ac.uk/subjects/Financial%
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