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    Financial Economics: A Simple Introduction
    Financial Economics: A Simple Introduction
    Financial Economics: A Simple Introduction
    Ebook99 pages1 hour

    Financial Economics: A Simple Introduction

    By K.H. Erickson

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    About this ebook

    Financial Economics: A Simple Introduction offers an accessible guide to the central ideas and methods of financial economics, with examples and calculations, empirical evidence, and over 20 diagrams to support the analysis.

    Understand consumption and investment decisions, intertemporal choice, indifference curves and the marginal rate of substitution, production possibilities and the marginal rate of transformation, rates of return, the financial market line, borrowing and lending, and the Fisher Separation Theorem.

    Portfolio theory examines expected returns, standard deviation and variance risk, covariance, correlation, asset diversification, market portfolio, a risk-free asset, the capital market line, and the Tobin Separation Theorem.

    The capital asset pricing model (CAPM) explores diversifiable and non-diversifiable risk, the beta risk factor, calculation of an asset’s expected return, the security market line, asset evaluation, and empirical evidence on the CAPM.

    Market efficiency looks at the efficient market hypothesis (EMH), weak, semi-strong, and strong form efficiency, and the literature on technical and fundamental analysis strategies to beat the market.

    LanguageEnglish
    PublisherK.H. Erickson
    Release dateOct 25, 2013
    ISBN9781311571991
    Financial Economics: A Simple Introduction

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      Book preview

      Financial Economics - K.H. Erickson

      Financial Economics: A Simple Introduction

      By K.H. Erickson

      Copyright © 2013 K.H. Erickson

      All rights reserved.

      No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the author.

      Also by K.H. Erickson

      Simple Introductions

      Choice Theory

      Financial Economics

      Game Theory

      Game Theory for Business

      Investment Appraisal

      Microeconomics

      Table of Contents

      1 Introduction

      2 Consumption and Investment

      2.1 Intertemporal Choice

      2.2 Production Possibility Frontier

      2.3 Borrowing and Lending

      2.4 Fisher Separation Theorem

      3 Portfolio Theory

      3.1 Risk and Return

      3.2 Portfolio Diversification

      3.3 A Risk-Free Asset

      3.4 Market Portfolio and Capital Market Line

      4 Capital Asset Pricing Model (CAPM)

      4.1 Systematic Risk

      4.2 CAPM Assumptions and Expression

      4.3 Security Market Line and Asset Valuation

      4.4 Empirical Evidence on the CAPM

      5 Market Efficiency

      5.1 Efficient Market Hypothesis

      5.2 Beating the Market

      5.3 Weak Form Market Analysis

      5.4 Semi-Strong Form Market Analysis

      5.5 Strong Form Market Analysis

      Bibliography

      1 Introduction

      Financial economics is concerned with the allocation of resources in an uncertain environment, with a focus on monetary activities involving the trade of one form of money for another form, and on financial markets in particular. The subject area incorporates decision making at all levels, from uninformed consumers to qualified investment experts, market researchers and analysts, and the countless individuals who together bring about the self-adjusting market valuation system.

      Consumption and investment is the first area to be examined and individuals are faced with intertemporal choice, as they allocate consumption over time and invest the income that remains. Indifference curves and the marginal rate of substitution are introduced, to determine how an individual would like to divide consumption between now and the future, before the production possibility frontier shows the limits of consumption and the marginal rate of transformation between consumption over time. A third element is added with the financial market line, which allows borrowing or lending of wealth between periods, and calculations are shown to move between future and present value. In certain conditions there may be complete separation between the consumption choice and investment decision, known as the Fisher Separation Theorem, but if these conditions break down then individuals are revealed to face a sub-optimal outcome.

      Investment is looked at in-depth with an examination of portfolio theory. Expected return, standard deviation risk and variance are added to the discussion, along with the mathematical formulas used to calculate them. The main focal point of the topic is the gains on offer from portfolio diversification, and numerical examples and diagrams show how a well diversified portfolio can reduce risk without sacrificing the expected return. A risk-free asset is introduced with the market portfolio on the capital market line, and they’re revealed to be an essential part of an equilibrium portfolio.

      The capital asset pricing model (CAPM) is the focus of the next section, as investors must price assets to deal with non-diversifiable risk. This model combines the risk-free rate and market portfolio to find another efficient market line, as the security market line measures the expected return against beta risk, which represents the sensitivity of an asset to market changes. Numerical examples are given to calculate the expected return of an asset if the other factors are known, and also to estimate beta in a range of scenarios. Assets may not necessarily place on the security market line, potentially sitting below or above it as overvalued or undervalued stocks, and this can challenge the entire validity of the CAPM as an asset valuation tool. Empirical evidence on the strengths and weaknesses of the model ends the section.

      The final topic turns to the question of market efficiency, which is central to the idea of efficient market lines and market portfolios throughout financial economics. An efficient market hypothesis is put forward with the idea that prices follow a random walk, and this is separated into weak, semi-strong and strong levels of efficiency, but professional analysts may work on the basis that markets are inefficient, and the methods they may use to gain excess returns are outlined. An extensive analysis is then made on weak, semi-strong and strong form levels of market efficiency, using research from others to summarize the empirical evidence and draw conclusions on the state of the market.

      2 Consumption and Investment

      2.1 Intertemporal Choice

      The ways that firms and individuals allocate resources through time is a central focus in financial economics, and the field is known more broadly as intertemporal choice. Capital markets are an essential part of this process, and they allow individuals to exchange resources available at one period in time for resources at another time, while the production or investment decisions of firms transform current physical assets into future resources.

      A sum of money could be invested in a five year fixed rate savings account today, and in five

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