Financial Economics

Financial economics is a discipline concerned with determining value and

making decisions.
- Introduce to general equilibrium theory, macroeconomics, or finance three
fields that have moved closer to each other over the last two decades.
- Knowledge of modern finance is crucial for those looking for a greater
understanding of topics in economics and public policy, such as:
- Exchange rate determination,
- International capital flows,
- monetary and Fiscal policy, and financial reform in developing economies,
regulation, and antitrust policy.
 FINANCIAL ECONOMICS

The financial economics major at integrates the theory of finance with a broad
background in economics. It includes economics courses and mathematics than
the typical finance.
 Meaning of Financial System
• Financial system is a system that facilitates the movement of funds among
people in an economy. It is simply a means through which funds are exchanged
between investors, lenders, and borrowers.
A financial system is composed of various elements like:
• Financial institutions,
• Financial intermediaries,
• Financial markets and
• Financial instruments which all together facilitate the smooth transfer of funds.
 Role of Financial System
1.Transfer Funds

• Financial system helps in transferring of financial resources from one person to

another person. This system includes financial markets, financial intermediaries,
financial assets and services which facilitates fund movements in an economy.

2.Mobilizes Saving

• It helps in allocating ideal lying resources with peoples into productive means.

• Financial system is the one which obtains funds from savers and provide it to
those who are in need of it for various development purposes.
Cont’d…

3.Risk Allocation
• Diversification of risk in an economy is important feature of financial
system. Financial system allocates people’s funds in various sources due to
which risk is diversified.
4.Facilitates Investment
• Financial system encourages investment by peoples into different
investment avenues.
• It provides various income-generating investment options to peoples for
investing their savings.
Cont’d…
5.Enhances Liquidity

• Financial system helps in maintaining optimum liquidity in an economy.

• It facilities free movement of funds from households (savers) to corporates

(investors) which ensures sufficient availability of funds.
 Cont’d…
6.Facilitates Payment Mechanism
• Financial system provides a payment mechanisms for the smooth flow of funds among peoples in an
economy. Buyers and sellers of goods or services are able to perform transactions with each other due
to the presence of a financial system.
7.Reduces Risk
• It aims at reducing the risk by diversifying it among a large number of individuals. Financial system
distributes funds among a large number of peoples due to which risk is shared by many peoples.
8. Brings Savers and Investors Together
• Financial system serves as a means of bridging the gap between savings and investment. It acquires
money from those with whom it is lying idle and transfers it to those who need it for investing in
productive ventures.
 Cont’d…
9. Assist In Capital Formation
• Financial system has an efficient role in the capital formation of the country. It enables big corporates and
industries to acquire the required funds for performing or expanding their operations thereby leading to
capital formation in the nation.
10. Improves Standard of Living
• It raises the standard of living of peoples by promoting regional and rural development of the country. The
financial system promotes the development of a weaker sections of society through cooperative societies and
rural development banks.
11.Facilitates Economic Development
• Financial system influences the pace of economic growth or development of an economy. It aims at
optimum utilization of all financial resources by investing all idle lying resources into useful means, which
leads to the creation of wealth.
 1.1.Structure Of Financial System
The Structure of financial system consists of :

• Individuals

• Intermediaries

• Markets and

• Uses Of Savings.

• Economic activity and growth are greatly facilitated by the existence of financial
system developed in terms of the efficiency of the market in mobilizing savings and
allocating them among competing users.
 Structure Of Financial System
• Financial Intermediaries: Financial intermediaries play a vital role in economic
development via capital formation. Their relevance to the flow of savings is derived
from what is called transmutation effect. This term refers to the ability of the
financial intermediaries to convert contracts with a given set of characteristics into a
contract with very different features.
 Cont’d…
Types of financial intermediaries are:
 Commercial Banks,
Non-banking Financial Companies,
Mutual Funds,
Insurance Organization.
Primary securities are issued by non-financial economic units.
Indirect securities are financial assets issued by financial intermediaries.
• Services: The services or economies provided by the financial intermediaries that tailor
financial assets to the desires of savers and investors are: (i) convenience, (ii) lower risk,
(iii) expert management, and (IV) economies of scale.
 Cont’d…
• Convenience: Financial intermediaries provide convenience in two forms (i) first is
divisibility, they divide primary securities of higher denomination into indirect securities of
lower denominations so that even savings can be tapped from small pockets for ultimate
investments in real assets. The other (ii) of indirect securities is their ability to transform a
primary security of a certain maturity into an indirect security of different maturity.
• Lower risk: Indirect securities also have the merit of exposing investors to lower risk as
compared to primary securities. This is mainly because of the benefits of ‘diversification’ that
become available to even small investors.
• Besides, economies of scale and expert management services are provided by financial
intermediaries. Savings are institution elastic. The volume of savings as well as direction is
considerably influenced by the structure of financial intermediaries.
 2. Financial Markets

Financial Markets: Financial intermediaries are source of finance between

saving and investment while financial markets are not source of finance but link
between savers and investors both individual as well as institutional. Financial
markets perform a crucial function in the savings-investment process as
facilitating organizations. Based on the nature of funds which are their stock-in-
trade, the financial markets are classified into (1) Money Market and (2)
Capital/Securities Market.
 Cont’d…
• Money Market: Money market is a market for dealing in monetary assets of short-
term nature. The major participants in the money market are the RBI and commercial
banks. The major objectives are:

 An equilibrating mechanism for evening out short-term surpluses and deficiencies,

 A reasonable access to the users of short-term funds to meet their requirements at

realistic/reasonable/price/cost.

• Money market comprises number of interrelated sub-markets, that is, call money
market, treasury bill market, commercial bill market, commercial paper, certificate of
deposits market, money market mutual funds and repo (repurchase) market and so on.
 Cont’d…
Capital Market: It is a market for long term funds. Its focus is on financing of fixed investment in contrast to
money market which is the institutional source of working capital finance.

The Main Participants In The Capital Market Are:

 Mutual Funds,

 Insurance Organizations,

 Foreign Institutional Investors,

 Corporates and

 Individuals.

The capital market has two segments:

• (1) Primary/new issue market, and

• (2) Secondary market/stock exchange(s) market (s)

 Cont’d…
• Primary/new issue market (NIM): The NIM deals in new securities, that is, securities were
not previously available and are offered to the investors for the first time. Capital formation
occurs in NIM as it supplies additional funds to the corporates directly. It does not have any
organizational setup located in any particular place and is recognized only by the specialist
institutional services that it tenders to the lenders/ borrowers (buyers/sellers) of capital funds
at the time of any particular operation. It performs triple-service/function, viz.
• (i) origination that is investigation and analysis and processing of new issue proposals;
• (ii) underwriting, in terms of guarantee that the issue would be sold irrespective of public
response and
• (iii) distribution of securities to the investors.
Cont’d…
• Secondary market/stock exchange(s) market (s): The stock exchange is a
market for old or existing securities, that is, those already issued and granted
stock exchange quotation/listing. It plays only an indirect role in industrial
financing by providing liquidity to investments already made. It has physical
existence and is located in a particular geographical area.
• The stock exchange discharges three vital functions in the orderly growth
of capital formation:
(i) nexus between savings and investments;
(ii) liquidity to investors by offering a place of transaction in securities;
(iii) continuous price formation
 3. Financial Assets/Instruments (Securities)
Financial Assets/Instruments (Securities): They represent claims on a stream of income and/or assets of another economic unit and
are held as a store of value and for the return that is expected. The financial assets fall into three broad categories:

(i) Direct/primary;

(ii) Indirect and

(iii) Derivatives.

DIRECT/PRIMARY SECURITIES: DIRECT/PRIMARY SECURITIES ARE:

• Equity/Ordinary Shares: They are ownership securities and represent risk capital. The owners of such security bear the risk, are
residual claimants on the income and assets and participate in management of the company.

• Debentures: A debenture is a creditorship security. Their holders are entitled to a pre-specified interest rate and first claim on the
assets of the entity. They have no right to vote in the meetings of the company. Debentures can be either bearer/ negotiable/ transferable
by delivery or registered which are payable to the registered holders only. They can be secured or unsecured/naked. Debentures can be
convertible and non-convertible into equity shares.
Cont’d…

• Preference Shares: A preference share is hybrid security and partakes the

features of both equity and debentures. It combines both ownership and
creditorship privileges. The holders of such security have preference over the
equity holders in respect of fixed dividend as well as return of capital.

• Warrants: These are also referred to as sweeteners. A warrant is a security

which entitles the holders to purchase a specified number of shares at a stated
price before a stated date/period. They are issued with either debentures or
equity shares.
Cont’d…

• Indirect Securities/Financial Assets: Indirect securities are

financial assets issued by financial intermediaries such as units of
mutual funds, policies of insurance companies, deposits of banks
and so on. The indirect financial assets are coined from the
underlying primary security and bearing their own utilities

• Derivatives are the financial assets where investors trade

instruments like futures and options.
 1.2.Role Of Financial System In Economic Development

1. Savings-investment relationship

• To attain economic development, a country needs more investment and

production. This can happen only when there is a facility for savings. As, such
savings are channelized to productive resources in the form of investment.

• Here, the role of financial institutions is important, since they induce the public
to save by offering attractive interest rates. These savings are channelized by
lending to various business concerns which are involved in production and
distribution.
 Cont’d…
2. Financial systems help in growth of capital market
• Every business requires two types of capital namely, fixed capital and working capital.
Fixed capital is used for investment in fixed assets, like plant and machinery. While working
capital is used for the day-to-day running of business. It is also used for purchase of raw
materials and converting them into finished products.
 Fixed capital is raised through capital market by the issue of debentures and shares.
Public and other financial institutions invest in them in order to get a good return with
minimized risks.
 Working capital is getting through money market, where short-term loans could be
raised by the businessmen through the issue of various credit instruments such as bills,
promissory notes, etc.
 Contd…
3. Foreign exchange market
• It enables the exporters and importers to receive and raise the funds for settling transactions. It also
enables banks to borrow from and lend to different types of customers in various foreign currencies. The
market also provides opportunities for the banks to invest their short term idle funds to earn profits. Even
governments are benefited as they can meet their foreign exchange requirements through this market.
4. Government Securities market

• Financial system enables the state and central governments to raise both short-term and long-term
funds through the issue of bills and bonds which carry attractive rates of interest along with tax
concessions. Thus, the capital market, money market along with foreign exchange market and
government securities market enable businessmen, industrialists as well as governments to meet their
credit requirements. In this way, the development of the economy is ensured by the financial system.
Cont’d…
5. Infrastructure and growth
• Economic development of any country depends on the infrastructure facility available in
the country. In the absence of key industries like coal, power and oil, development of other
industries will be hampered. It is here that the financial services play a crucial role by
providing funds for the growth of infrastructure industries. Private sector will find it
difficult to raise the huge capital needed for setting up infrastructure industries. For a long
time, infrastructure industries were started only by the government in India. But now, with
the policy of economic liberalization, more private sector industries have come forward to
start infrastructure industry. The Development Banks and the Merchant banks help in
raising capital for these industries.
6. Development of trade

• The financial system helps in the promotion of both domestic and foreign trade. The
financial institutions finance traders and the financial market helps in discounting
financial instruments such as bills.

7. Employment growth is boosted by financial system

• The presence of financial system will generate more employment opportunities in

the country.

• Various financial services such as leasing, factoring, merchant banking, etc., will also
generate more employment. The growth of trade in the country also induces
employment opportunities. Financing by Venture capital provides additional
opportunities for techno-based industries and employment.
8. Venture capital
• The economic development of a country will be rapid when more ventures are promoted which
require modern technology and venture capital.
• Venture capital cannot be provided by individual companies as it involves more risks. It is only
through financial system, more financial institutions will contribute a part of their investable funds for
the promotion of new ventures. Thus, financial system enables the creation of venture capital.
9. Financial system ensures balanced growth
• Economic development requires a balanced growth which means growth in all the sectors
simultaneously. Primary sector, secondary sector and tertiary sector require adequate funds for their
growth. The financial system in the country will be geared up by the authorities in such a way that the
available funds will be distributed to all the sectors in such a manner, that there will be a balanced
growth in industries, agriculture and service sectors.
10. Fiscal discipline and control of economy

• It is through the financial system, that the government can create a congenial business
atmosphere so that neither too much of inflation nor depression is experienced.

• The government can also regulate the financial system through suitable legislation so
that unwanted or speculative transactions could be avoided. The growth of black money
could also be minimized.

11. Financial system’s role in balanced regional development

• Through the financial system, backward areas could be developed by providing various concessions. This
ensures a balanced development throughout the country and this will mitigate political or any other kind of
disturbances in the country.

• It will also check migration of rural population towards towns and cities.
12. Attracting foreign capital

• Financial system promotes capital market. A dynamic capital market is capable

of attracting funds both from domestic and abroad. With more capital, investment
will expand and this will speed up the economic development of a country.

13. Economic Integration

• Financial systems of different countries are capable of promoting economic

integration. This means that in all those countries, there will be common
economic policies, such as common investment, trade, commerce, commercial
law, employment legislation etc.
14.Political Stability
• The political conditions in all the countries with a developed financial system will be stable. Unstable
political environment will not only affect their financial system but also their economic development.
15. Uniform interest rates

• The financial system is capable of bringing a uniform interest rate throughout the country by which
there will be balanced movement of funds between centers which will ensure availability of capital for
all kinds of industries
16. Electronic development
• Due to the development of technology and the introduction of computers in the financial system, the
transactions have increased manifold bringing in changes for the all-round development of the country.
The promotion of World Trade Organization (WTO) has further improved international trade and the
financial system in all its member countries.
 1.3 Asset Transformation Role Of Financial Institutions
Asset Transformation can be described as:
• Asset transformation can be described into two ways. One is the way of bank and another is in the way of financial
intermediary. They are quite different from one another. But there is a common. Both of them means turning something
into asset or changing the shape of asset.

• Asset Transformation
• A type of transformation whereby banks use deposits (mobilized funds) to generate revenue by pooling deposits to
make loans. More specifically, asset transformation is the process of transforming bank liabilities (deposits) into bank
assets (loans).
• By nature, deposits are subject to withdrawal by customers (depositors) at any point in time or as stipulated in the
deposit contract/agreement. Loans are bank assets because they represent money that the bank lends and expect to receive
back in the form of principal and interest payments.
 1.3 Asset Transformation Role Of Financial Institutions

As such, banks undertake asset transformation by lending long and borrowing short,

with the interest rate differential being its transformation revenues. Typically, banks

and other financial institutions perform asset transformation by offering their

customers a variety of financial products on both sides of the balance sheet such as

deposits, investment and loan products, etc.

•
 What is securitization?

• Securitization is the process of taking an illiquid asset or group of

asset and transform them into security. For example: An institution
creates several mortgage backed up by the claims against the
mortgagors' asset. They transform them into securities and sell it. Who
will buy the share will get the money the mortgagor will pay.
 1.4 Debt and Inalienability of Human Capital

• Debt is something, usually money, owed by one party to another. Most

debts—such as credit cards, home loans, and auto loans—are categorized
as secured, unsecured, revolving, or mortgaged. Corporations often have
varying types of debt, including corporate debt. Corporate debt involves the
issuance of bonds to investors to generate capital, often for projects. Debt can
be used to fund needed projects, fulfil the dream of homeownership, or pay for
higher education…

• Human Capital is a measure of the skills, education, capacity and attributes

of labour which influence their productive capacity and earning potential.
 Factors That Determine Human Capital
 Skills and qualifications
 Education levels
 Work experience
 Social skills – communication
 Intelligence-thinking ability
 Judgement
 Personality – hard working, harmonious in an office
 Habits and personality traits
 Creativity. Ability to innovate new working practices/products.
 Fame and brand image of an individual. e.g. celebrities paid to endorse a product.
 Geography – Social peer pressure of local environment can affect expectations and attitudes.
 How to increase human capital
1. Specialization and division of labour.
2. Education.
3. Vocational training.
4. A climate of creativity
5. Infrastructure.
6. Competitiveness.
 Importance of human capital

1. Structural unemployment.
2. Quality of employment.
3. Economic growth and productivity
4. Human capital flight.
5. Limited raw materials.(skilled value raw materials)
6. Sustainability
 1.5. Introduction to Financial Instruments

• A financial instrument is a contract between two parties that gives rise to

a financial asset of one party and a financial liability or equity of the other party.
• Firstly, a financial instrument must have a contractual arrangement.
For instance, income tax payable by an entity has the characteristics of financial
liability for the entity, and it also has the characteristics of financial asset for the
Income Tax Department. But is it a financial instrument? No, as this is a statutory
obligation and not a contractual obligation, therefore, it is not a financial instrument.
• Definitions of financial assets, financial liabilities and equity instruments are
given below.
 Financial instruments( Assets)
Any asset that is either:
 Cash
 Contractual right to receive cash
 Contractual right to receive another financial asset
 Contractual right to exchange a financial instrument under favorable conditions, or
 An equity instrument of another entity
Examples of financial assets include cash and cash equivalents, accounts receivable,
investment in debentures, investment in bonds and treasury certificates, investment
in ordinary shares of another entity etc.
 Financial liability
Any liability that is either:
 Contractual obligation to pay cash
 Contractual obligation to transfer another financial asset
 Contractual obligation to exchange a financial instrument under unfavorable
conditions, or
 Contractual obligation that will or may be settled in the form of an entity’s
own equity instruments (for example, convertible loan)
Examples of financial liabilities include accounts payable, loans payable,
debentures, bonds payable, redeemable preference shares etc.
 Equity Instrument
• Any instrument issued by an entity that gives a contractual right to the net
assets of the entity (ownership rights) to the instrument holder. For example,
ordinary shares of an entity are equity instruments.

Investments in financial instruments

• Entities invest money in financial instruments mainly to earn investment

income. An entity either intends to hold financial assets to earn interest income
or dividend income, or purchases financial assets to earn capital gains by
selling the financial assets. Depending on the individual circumstances of an
entity, these investments can be long term or short term.
 Equity Instrument
By nature, financial instruments are mainly categorized into following categories:

 Equity instruments-are papers that demonstrate an ownership interest in a

business.

 Debt instruments-referred to as loans, mortgages, leases, notes, and bonds, act

as a contractual agreement between a financial institution and a borrower.

 Derivatives-In finance, a derivative is a contract that derives its value from the
performance of an underlying entity.
 Risk and Return
• The meaning of return is simple. The return on an investment is the result that you achieve in proportion to
its value. When you buy a share for $10 and you achieve $1 in return because the price increases, your return is
1%.

• Investment risks are all things that can cause the value of your investment to plummet. Not all investment
products have the same risk. In this article, you will discover the relationship between risk & return.

What is the relationship between risk and return?

• Without risk, you will not achieve a (good) return. When you put money in the bank, you always lose. The
low interest does not outweigh the inflation. Over time this means that your capital decreases in value.
Cont’d…
• Saving your money on a bank does not make you rich. Saving does have the advantage of being practically
risk-free. The chance that a bank will fail is quite small, even in times of crisis. And when this does eventually
happen, many governments will step up and ensure that you won’t lose your deposit. If you want to obtain a
better return, you should look into investment opportunities.

• As an investor, you are paid to take risks. People don’t just invest their hard-earned money: they expect
something in return. In this article, we look at the relationship between risk and return for the most popular
investment products. You can directly navigate to a specific type of investment to learn more:

 Time deposit: you receive a fixed amount of monthly interest

 Bonds: you lend money to a company or government

 Shares: you trade in the price development of shares

 Real estate: you can for example buy a second home

 Derivatives: the most risky option with potential high rewards

 Portfolio theory.
• The modern portfolio theory (MPT) is a practical method for selecting investments
in order to maximize their overall returns within an acceptable level of risk.

• American economist Harry Markowitz pioneered this theory in his paper "Portfolio
Selection," which was published in the Journal of Finance in 1952. He was later
awarded a Nobel Prize for his work on modern portfolio theory.

• A key component of the MPT theory is diversification. Most investments are either
high risk and high return or low risk and low return. Markowitz argued that investors
could achieve their best results by choosing an optimal mix of the two based on an
assessment of their individual tolerance to risk.
 Acceptable Risk

• The MPT assumes that investors are risk-averse, meaning they prefer a less risky
portfolio to a riskier one for a given level of return. As a practical matter, risk
aversion implies that most people should invest in multiple asset classes.

• The expected return of the portfolio is calculated as a weighted sum of the returns
of the individual assets. If a portfolio contained four equally weighted assets with
expected returns of 4%, 6%, 10%, and 14%, the portfolio's expected return would be:

• (4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

 Cont’d…

• Pricing models, such as the Capital Asset Pricing Model and Index Model

What Is the Capital Asset Pricing Model?

• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic

risk and expected return for assets, particularly stocks. CAPM is widely used throughout

finance for pricing risky securities and generating expected returns for assets given the risk

of those assets and cost of capital.

 Understanding the Capital Asset Pricing Model (CAPM)
• The formula for calculating the expected return of an asset given its risk is as follows:
• ERi​=Rf​+βi​(ERm​−Rf​)
• where:
• ERi​=expected return of investment
• Rf​=risk-free rate
• βi​=beta of the investment
• (ERm​−Rf​)=market risk premium
• The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and
the time value of money are compared to its expected return.
Cont’d…

• For example, imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared to the market
of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market to rise in value by 8% per year.

• The expected return of the stock based on the CAPM formula is 9.5%:

• 9.5%=3%+1.3×(8%−3%)
Cont’d…
• The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such
models used to calculate the optimum portfolio.
• Sharpe (1963) defined SIM as an asset pricing model which is purely arithmetical. The
returns on a security can be represented as a linear relationship with any economic variable
relevant to the security, for example in stocks the single factor is the market return. According
to Sharpe the Single index model for return on stocks is shown by the formulae shown below;
• Ri= α + β (Rm) +ε. α or alpha represents abnormal returns for stock.
• Β (Rm) represents the markets movement. ε represents the unsystematic risk of the security.
 Capital Allocation
• Capital allocation is about where and how a corporation's chief executive
officer (CEO) decides to spend the money that the company has earned.

• Capital allocation means distributing and investing a company's financial

resources in ways that will increase its efficiency, and maximize its profits.
 Market efficiency
• Market efficiency is a relatively broad term and can refer to any metric that measures information
dispersion in a market.

• An efficient market is one where all information is transmitted perfectly (everyone receives the
information), completely (everyone receives the entire information), instantly (everyone receives the
information at once), and for no cost (everyone receives the information for free).

• The notion of market efficiency is closely tied to the Efficient Market Hypothesis, which was
developed by Eugene Fama, an American financial economist. Fama built on the work done by other
financial economists such as Harry Markowitz, Fischer Black, Myron Scholes, Jack Treynor, William
Sharpe, Merton Miller, Franco Modigliani, John Lintner, Jan Mossin, and Robert Merton.
 Cont’d…
• An efficient market is characterized by a perfect, complete, costless, and instant
transmission of information. Asset prices in an efficient market fully reflect all
information available to market participants. As a result, it is impossible to ex-ante
make money by trading assets in an efficient market.
• The result provides an alternate definition of market efficiency, which is
particularly popular among financial markets participants – An efficient market is
any market where asset price movements can’t be consistently estimated, i.e., it is
impossible for an investor to consistently make money in an efficient market by
trading financial assets.
Cont’d…

The fundamental factors affecting the stock. The factors can be broadly
classified into four categories.

1. Macroeconomic variables

2. Management of the business

3. Financial health of the business

4. Profits of the business

The end of 1st chapter