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Financial Economics

Financial Economics:

This is a branch of economics, which is concerned with resource allocation over a period of time. This discipline deal with the operations of financial markets such stock, bond, Forex, commodities etc. this includes the subjects like, hedging, savings, investing, funding, budgeting, asset management & diversification, etc.

This discipline is based on several assumptions & concepts. Chief or major assumptions are financial decision makers all are rational, experimental economics & experimental finance.

Major concepts are:

1. Risk free interest rates: - this is the minimum interest rate which the investor would have got with no risk. Usually there is very less risk free asset in practical, government bonds, treasury bills, etc are treated as risk free securities. This is one of the crucial elements for calculation of derivative price or expected rate of return.

2. Time value of money: - this implies that $1 today is not equivalent to $1 a year later. Money will always loose its value over a period of time due to several facts affecting to its purchasing power. If you would have invested $1 today for 1 year with 6% interest rate per annum, you will receive $1.06 at the time of expiry of the investment. So the time difference between today and future date fetch money value. That is to be calculated for understanding various other concepts of financial economics.

3. Fisher separation theorem: - this theory emphasis that an organizations prime objective should be to increase its present value, with out regarding managements preference. This theory thus separates managements productive opportunities from entrepreneurs market opportunities.

4. Modigliani Miller theory: - this theory says that in an efficient market a firm is unaffected by how that firm is being financed in the absence of taxes, bankruptcy costs and asymmetric information. It is not a matter of fact whether the firm has raised its capital through the issue of equities or debts and how the dividend policy is.

5. Arbitrage: - it is the practice of taking advantage of price difference in two or three markets for the same product. In case of dollar/rupee its opens with bit difference in offshore and onshore market, so banks usually take opposite positions in both the market to take advantage of this difference. Thus gaining a risk free margin trade.

6. Rational pricing: - this implies that every asset must have arbitrage free price, and any deviation from this price will be arbitraged away by the market makers. This theory is mainly useful for field income securities like, bonds, treasury bills, etc and also for derivative pricing.

7. Efficient market theory: - this theory explains a market condition were all the financial instruments will reflect the known fundamental facts without any baize. Unknown facts or internal information are exception to this and can bring changes to the asset price in future.

8. Modern portfolio theory: - This theory emphasis how best a risky asset must be priced and how the investors are utilizing the diversification procedure to manage portfolio. The very basic concepts of this theory are Markowitz Diversification, CAPM, beta coefficient, the efficient frontier, alpha coefficient, the capital market line and the securities market line.

9. Yield curve: - This is a curve which best describes the relation between the interest rate and time to maturity of the debt. This is the graphical representation of the securities on which interest are being paid for different maturities by the market makers. Market operators use to closely watch this yield curves to project the interest rate movements in future.

All the above-mentioned theories and concepts are best supporting and defining economics of finance. One must b able to understand the practicality of this financial terminologies, so that best corporate financial management can be achieved. The major advantages of this financial economics will come at the time of funding or budgeting a project.

This is one of the integral parts of the financial model. For conducting a project evaluation best examples are as follows.

One exporter has to fulfill his commitment to his buyer worth $1 million. He as two options with him one is funding through rupee advance from bank or availing a PCFC.

Dollar rupee rate as on date is Rs.46.00.

From the financial point of view, he must do a comparative analysis of both the products offered by the banker.

If he avails rupee advance he has to pay an interest rate of 7-8% per annum and for PCFC he has to pay 5-6%, but he has to make the payments in rupee so here if we prefer PCFC then a currency risk is coming into the picture for the period of inflow and outflow. If the spot is at 46.00 and next six months view for the rupee is to appreciate towards 45 it will be beneficial for the corporate to take PCFC and he will get cheaper working capital and gain in FX. So a complete study of entire scenario is must for taking any decisions on corporate funding. If the spot is at 44.00 then using PCFC is bit riskier for making domestic payment.

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