Financial economics

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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 prices, interest rates and shares, 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 underpin 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] 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 is built
on the foundations of microeconomics and decision theory.
Financial econometrics is the branch of financial economics that uses econometric
techniques to parameterise these relationships. Mathematical finance is related in
that it will derive and extend the mathematical or numerical models suggested by
financial economics. The emphasis there is mathematical consistency, as opposed
to compatibility with economic theory. Financial economics has a
primarily microeconomic focus, whereas monetary economics is
primarily macroeconomic in nature.
Financial economics is usually taught at the postgraduate level; see Master of
Financial Economics. Recently, specialist undergraduate degrees are offered in the
discipline.[4]
This article provides an overview and survey of the field: for derivations and more
technical discussion, see the specific articles linked.

Contents

 1Underlying economics
o 1.1Present value, expectation and utility
o 1.2Arbitrage-free pricing and equilibrium
o 1.3State prices
 2Resultant models
o 2.1Certainty
o 2.2Uncertainty
 3Extensions
o 3.1Portfolio theory
o 3.2Derivative pricing
o 3.3Corporate finance theory
 4Challenges and criticism
o 4.1Departures from normality
o 4.2Departures from rationality
 5See also
 6References
 7Bibliography
 8External links

Underlying economics[edit]
Fundamental valuation result

Four equivalent formulations,[5] where:

  is the asset or security
 are the various states
 is the risk-free return
 dollar payoffs in each state
 a subjective, personal probability
assigned to the state; 
 risk aversion factors by state,
normalized s.t. 
 the stochastic discount factor
, risk neutral probabilities
 state prices; 

As above, the discipline essentially explores how rational investors would

apply decision theory to the problem of investment. The subject is thus built on the
foundations of microeconomics and decision theory, and derives several key results
for the application of decision making under uncertainty to the financial markets. The
underlying economic logic distills to a ”fundamental valuation result”, [5][6] as aside,
which is developed in the following sections.
Present value, expectation and utility[edit]
Underlying all of financial economics are the concepts of present
value and expectation.[5]
Calculating their present value allows the decision maker 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 thus more readily compare two opportunities;
this concept is therefore the starting point for financial decision making. (Its history is
correspondingly early: Richard Witt discusses compound interest in depth already in
1613, in his book "Arithmeticall Questions"; [7] further developed by Johan de
Witt and Edmond Halley.)
An immediate extension is to combine probabilities with present value, leading to
the expected value criterion which sets asset value as a function of the sizes of the
expected payouts and the probabilities of their occurrence,  and  respectively.
(These ideas originate with Blaise Pascal and Pierre de Fermat in 1654.)
This decision method, however, fails to consider risk aversion ("as any student of
finance knows"[5]). 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; see also Ellsberg
paradox. (The development here is originally due to Daniel Bernoulli in 1738, and
later formalized by John von Neumann and Oskar Morgenstern in 1947.)
Arbitrage-free pricing and equilibrium[edit]
JEL classification codes

In the Journal of Economic Literature

classification codes, Financial Economics
is one of the 19 primary classifications, at
JEL: G. It
follows Monetary and International
Economics and precedes Public
Economics. For detailed
subclassifications see JEL classification
codes § G. Financial Economics.
The New Palgrave Dictionary of
Economics (2008, 2nd ed.) also uses the
JEL codes to classify its entries in v. 8,
Subject Index, including Financial
Economics at pp. 863–64. The below
have links to entry abstracts of The New
Palgrave Online for each primary or
secondary JEL category (10 or fewer per
page, similar to Google searches):
JEL: G – Financial Economics
JEL: G0 – General
JEL: G1 – General Financial
Markets
JEL: G2 – Financial
institutions and Services
JEL: G3 – Corporate
finance and Governance
Tertiary category
entries can also be
searched.[8]

The concepts of arbitrage-free, "rational", pricing and equilibrium are then coupled
with the above to derive "classical"[9] (or "neo-classical"[10]) 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. [11] 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.
The formal derivation will proceed by arbitrage arguments. [5][11] 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
(i.e. implied) probabilities, and in turn, the derived distribution, or "measure".
With this measure in place, the expected, i.e. required, return of any security (or
portfolio) will then equal the riskless return, plus an "adjustment for risk", [5] i.e. a
security-specific risk premium, compensating for the extent to which its cashflows
are unpredictable. All pricing models are then essentially variants of this, given
specific assumptions and/or conditions.[5][6] This approach is consistent with the
above, but with the expectation based on "the market" (i.e. arbitrage-free, and, per
the theorem, therefore in equilibrium) as opposed to individual preferences.
Thus, continuing the example, in pricing a derivative instrument its forecasted
cashflows in the up- and down-states,  and , are multiplied through by  and , and are
then discounted at the risk-free interest rate; per equation above. In pricing a
“fundamental”, underlying, instrument (in equilibrium), on the other hand, a risk-
appropriate premium over risk-free is required in the discounting, essentially
employing the first equation with  and  combined. In general, this may be derived by
the CAPM (or extensions) as will be seen under #Uncertainty.
The difference is explained as follows: By construction, the value of the derivative
will (must) grow at the risk free rate, and, by arbitrage arguments, its value must then
be discounted correspondingly; in the case of an option, this is achieved by
“manufacturing” the instrument as a combination of the underlying and a risk free
“bond”; see Rational pricing § Delta hedging (and #Uncertainty below). Where the
underlying is itself being priced, such construction is of course not possible - the
instrument being "fundamental" - and a premium is then required for risk.
State prices[edit]
With the above relationship established, the further specialized Arrow–Debreu
model may be derived. This important result suggests that, under certain economic
conditions, there must be a set of prices such that aggregate supplies will equal
aggregate demands for every commodity in the economy. The analysis here is often
undertaken assuming a representative agent.[12] 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.
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 second 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. See also Stochastic
discount factor.
State prices find immediate application as a conceptual tool ("contingent claim
analysis");[5] but can also be applied to valuation problems. [13] 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. [14][13] 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. (Breeden and
Litzenberger's work in 1978[15] established the use of state prices in financial
economics.)

Resultant models[edit]

Modigliani–Miller Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and its upward sloped
portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the
efficient frontier. The graphic displays the CAL, Capital allocation line, formed when the risky asset is a
single-asset rather than the market, in which case the line is the CML.
The Capital market line is the tangent line drawn from the point of the risk-free asset to the feasible
region for risky assets. The tangency point M represents the market portfolio. The CML results from the
combination of the market portfolio and the risk-free asset (the point L). Addition of leverage (the point R)
creates levered portfolios that are also on the CML.

The capital asset pricing model (CAPM):

The expected return used when discounting
cashflows on an asset , is the risk-free rate plus
the market premium multiplied by beta (), the asset's
correlated volatility relative to the overall market .

Security market line: the representation of the CAPM displaying the expected rate of return of an individual
security as a function of its systematic, non-diversifiable risk.

Simulated geometric Brownian motions with parameters from market data.

The Black–Scholes equation:

Interpretation: by arbitrage arguments, the
instantaneous impact of time  and changes
in spot price  on an option price  will (must)
realize as growth at , the risk free rate,
when the option is correctly hedged (i.e.
 "manufactured").

The Black–Scholes formula for the value of a

call option:
Interpretation: The value of a call is the risk
free rated present value of its expected in
the money value (i.e. a specific formulation
of the fundamental valuation result).  is the
probability that the call will be
exercised;  is the present value of the
expected asset price at expiration, given
that the asset price at expiration is above
the exercise price.

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 of capital,
the second of users of capital. Here, and for (almost) all other financial economics
models, the questions addressed are typically framed in terms of "time, uncertainty,
options, and information",[1][12] as will be seen below.

 Time: money now is traded for money in the future.

 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. (This division sometimes denoted
"deterministic" and "random",[16] or "stochastic".)
Certainty[edit]
The starting point here is “Investment under certainty". The Fisher separation
theorem, asserts that the objective of a corporation will be the maximization of its
present value, regardless of the preferences of 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.
The mechanism for determining (corporate) value is provided by The Theory of
Investment Value, which proposes that the value of an asset should be calculated
using "evaluation by the rule of present worth". Thus, for a common stock, the
intrinsic, long-term worth is the present value of its future net cashflows, in the form
of dividends. What remains to be determined is the appropriate discount rate. Later
developments show that, "rationally", i.e. in the formal sense, the appropriate
discount rate here will (should) depend on the asset's riskiness relative to the overall
market, as opposed to its owners' preferences; see below. Net present value (NPV)
is the direct extension of these ideas typically applied to Corporate Finance
decisioning. For other results, as well as specific models developed here, see the list
of "Equity valuation" topics under Outline of finance § Discounted cash flow
valuation. (John Burr Williams published his "Theory" in 1938; NPV was introduced
by Joel Dean in 1951)
Bond valuation, in that cashflows (coupons and return of principal) are deterministic,
may proceed in the same fashion.[16] 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.
Uncertainty[edit]
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.
Briefly, and intuitively—and consistent with #Arbitrage-free pricing and
equilibrium above—the relationship between rationality and efficiency is as follows.
[17]
 Given the ability to profit from private information, self-interested traders are
motivated to acquire and act on their private information. In doing so, traders
contribute to more and more "correct", i.e. efficient, prices: the efficient-market
hypothesis, or EMH. Thus, if prices of financial assets are (broadly) efficient, then
deviations from these (equilibrium) values could not last for long. (See Earnings
response coefficient.) The EMH (implicitly) assumes that average expectations
constitute an "optimal forecast", i.e. prices using all available information, are
identical to the best guess of the future: the assumption of rational expectations. The
EMH does allow that when faced with new information, 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 reliably exploited to make an abnormal profit. In the competitive limit, then, market
prices will reflect all available information and prices can only move in response to
news:[18] the random walk hypothesis. This news, of course, could be "good" or "bad",
minor or, less common, major; and these moves are then, correspondingly, normally
distributed; with the price therefore following a log-normal distribution. (The EMH
was presented by Eugene Fama in a 1970 review paper,[19] 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.)
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, [6] [18] [12] 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.
Relatedly, rationality — in the sense of arbitrage-exploitation — gives rise to Black–
Scholes; option values here ultimately consistent with the CAPM.
In general, then, while portfolio theory studies how investors should 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. Importantly, this result will be independent of the investor's level of
risk aversion, and / or assumed utility function, thus providing a readily determined
discount rate for corporate finance decision makers as above,[20] 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 plotting
as the capital market line, or CML. Then, given this CML, the required return on a
risky security will be independent of the investor's utility function, and solely
determined by its covariance ("beta") with aggregate, i.e. market, risk. This is
because investors 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 preceding, equaling the riskless return plus an adjustment for
risk.[6] A more modern, direct, derivation is as described at the bottom of this section;
which may be generalized to derive other pricing models. (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. )
Black–Scholes provides a mathematical model of a financial market
containing derivative instruments, and the resultant formula for the price
of European-styled options. The model is expressed as the Black–Scholes equation,
a partial differential equation describing the changing price of the option over time; it
is derived assuming log-normal, geometric Brownian motion (see Brownian model of
financial 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).[5][6] 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. (BSM - two seminal 1973 papers by Fischer
Black & Myron Scholes,[21] and Robert C. Merton [22] - is consistent with "previous
versions of the formula" of Louis Bachelier (1900) and Edward O. Thorp (1967);
[23]
 although these were more "actuarial" in flavor, and had not established risk-neutral
discounting.[10] See also Paul Samuelson (1965).[24] Vinzenz Bronzin (1908) produced
very early results, also. Itô's lemma - Kiyosi Itô, 1944 - provides the underlying
mathematics.)
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 expected return from the CAPM.
[25][10]
 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. [5] 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[edit]
More recent work further generalizes and / or 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[edit]

Plot of two criteria when maximizing return and minimizing risk in financial portfolios (Pareto-optimal points
in red)
Examples of bivariate copulæ used in finance.

See also: Post-modern portfolio

theory and Mathematical finance §  Risk and
portfolio management: the P world.
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 just market-based investments, into the
investor's calculation of required return.
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; Stephen Ross, 1976)
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." [26] 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.
As regards portfolio optimization, the Black–Litterman
model 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 (Thomas M. Cover, 1991) 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. See Portfolio optimization
§ Improving portfolio optimization for other techniques
and / or objectives.
Derivative pricing[edit]

Binomial Lattice with CRR formulae

See also: Mathematical finance §  Derivatives pricing:

the Q world
PDE for a zero-coupon bond:
Interpretation: Analogous to Black-Scholes,
arbitrage arguments describe the instantaneous
change in the bond price  for changes in the (risk-
free) short rate ; the analyst selects the
specific short-rate model to be employed.

Stylized volatility smile: showing the (implied) volatility by strike-

price, where the Black-Scholes formula returns market prices.
As regards derivative pricing, 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.[5][25][14] For path dependent
derivatives, Monte Carlo methods for option pricing are
employed; here the modelling is in continuous time, but
similarly uses risk neutral expected value. Various other
numeric techniques have also been developed. The
theoretical framework too has been extended such
that martingale pricing is now the standard approach.
Drawing on these techniques, models for various other
underlyings and applications have also been developed,
all based off the same logic (using "contingent claim
analysis"). Real options valuation 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 and / 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 bonds - additional to their derivatives - is
relatedly extended, particularly for hybrid securities,
where credit risk is combined with uncertainty re future
rates; see Bond valuation § Stochastic calculus
approach and Lattice model (finance) § Hybrid
securities. (Oldrich Vasicek developed his pioneering
short rate model in 1977.[27] The HJM framework
originates from the work of David Heath, Robert A.
Jarrow, and Andrew Morton in 1987.[28])
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: (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,
[29]
 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. This is because post-crisis, the overnight
rate is considered a better proxy for the "risk-free rate".
[30]
 (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[edit]
 Project valuation via decision tree.

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;[31] 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.[32] (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.)
More traditionally, decision trees—which are
complementary—have been used to evaluate projects,
by incorporating in the valuation (all) possible events (or
states) and consequent management decisions;[33][31] the
correct discount rate here reflecting each point's "non-
diversifiable risk looking forward."[31] (This technique
predates the use of real options in corporate finance; [34] it
is borrowed from operations research, and is not a
"financial economics development" per se.)
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,[35] 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. [36] [37] [38] [31] 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;[31][37] (essentially,  and  combined).
Other developments here include[39] 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. 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.
The typical application of real options is to capital
budgeting type problems as described. However, they
are also applied to questions of capital
structure and dividend policy, and to the related design
of corporate securities;[40] and since stockholder and
bondholders have different objective functions, in the
analysis of the related agency problems.[32] 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 state-
prices of the corporate's equity.[13][36]

Challenges and criticism[edit]

See also: Financial mathematics §  Criticism, Financial
engineering §  Criticisms, Financial Modelers'
Manifesto, Unreasonable ineffectiveness of
mathematics §  Economics and finance, and Physics
envy
As above, there is a very close link between (i)
the random walk hypothesis, with the associated
expectation 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[edit]

Implied volatility surface. The Z-axis represents implied volatility in

percent, and X and Y axes represent the option delta, and the days
to maturity.
See also: Capital asset pricing model
§  Problems, Modern portfolio theory §  Criticisms,
and Black–Scholes model §  Criticism and comments
As discussed, the assumptions that market prices follow
a random walk and / or that asset returns are normally
distributed are fundamental. Empirical evidence,
however, suggests that these assumptions may not hold
(see Kurtosis risk, Skewness risk, Long tail) and that in
practice, traders, analysts and risk managers frequently
modify the "standard models" (see Model risk). In
fact, Benoit Mandelbrot had discovered already in the
1960s 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.
Financial models with long-tailed distributions and
volatility clustering have been introduced to overcome
problems with the realism of the above "classical"
financial models; while jump diffusion models allow for
(option) pricing incorporating "jumps" in the spot price.
[41]
 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.[42] 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.[23][41] 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.[43]
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) 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.[44] Similarly purposed (and
derived) closed-form models have also been developed.
[45]

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 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." [46]
Departures from rationality[edit]
Market anomalies and Economic
puzzles

 Calendar effect
o January effect
o Sell in May
o Mark Twain
effect
o Santa Claus
rally
 Closed-end fund puzzle
 Dividend puzzle
 Equity home bias puzzle
 Equity premium puzzle
 Forward premium
anomaly
 Low-volatility anomaly
 Momentum anomaly
 Post-earnings-
announcement drift
 Real exchange-rate
puzzles
See also: Efficient-market hypothesis §  Criticism,
and Rational expectations §  Criticism
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.
Consistent with, and complementary to these
findings, various persistent market anomalies have
been documented, these being price and/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
equity investors should demand, an "abnormal
return". For further context see Random walk
hypothesis § A non-random walk hypothesis, and
sidebar for specific instances.
More generally, and particularly following
the financial crisis of 2007–2008, financial
economics and mathematical finance have been
subjected to deeper criticism; notable here is Nassim
Nicholas Taleb, who claims that the prices of
financial assets cannot be characterized by the
simple models currently in use, rendering much of
current practice at best irrelevant, and, at worst,
dangerously misleading; see Black swan
theory, Taleb distribution. A topic of general interest
has thus been financial crises, [47] and the failure of
(financial) economics to model (and predict) these.
A related problem is systemic risk: where companies
hold securities in each other then this
interconnectedness may entail a "valuation chain"—
and the performance of one company, or security,
here will impact all, a phenomenon not easily
modeled, regardless of whether the individual
models are correct. See Systemic risk § Inadequacy
of classic valuation models; Cascades in financial
networks; Flight-to-quality.
Areas of research attempting to explain (or at least
model) these phenomena, and crises,
include[12] noise trading, market microstructure,
and Heterogeneous agent models. The latter is
extended to agent-based computational economics,
where 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' approach
under § Reflexivity, financial markets, and economic
theory.
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
(attain "alpha").[48] 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.[49] Burton Malkiel's A Random
Walk Down Wall Street—first published in 1973, and
in its 12th edition as of 2019—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.) 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[edit]
 Category:Finance theories
 Category:Financial models
 Deutsche Bank Prize in Financial Economics
 Economic model
 Financial modeling
 Fischer Black Prize
 List of financial economists
 List of unsolved problems in economics
§ Financial economics
 Monetary economics
 Outline of economics
 Outline of finance
 Quantitative analyst § History
 Quantitative analyst § Seminal publications

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External links[edit]
Surveys Course material Links and portals
 Miller Merton H (2000). "The  Fundamentals of  JEL Classification Codes
History of Finance: An Eyewitness Asset Pricing, Guide
Account". Journal of Applied Prof. David K.  Financial Economics Links
Corporate Finance. 13 (2): 8– Backus, NYU, Stern on AEA's RFE
14. doi:10.1111/j.1745-  Financial  SSRN Financial Economics
6622.2000.tb00050.x. Economics: Classics Network
 Great Moments in Financial and Contemporary,  Financial Economics listings
Economics Prof. Antonio on economicsnetwork.ac.uk
I, II, III, IVa, IVb (archived, 2007- Mele, Università della
 Financial Economists
06-27). Mark Rubinstein Svizzera Italiana
Roundtable
 The Scientific Evolution of  Microfoundations
 NBER Working Papers in
Finance (archived, 2003-04-03). of Financial
Financial Economics
Don Chance and Pamela Peterson Economics Prof.
 The Early History of Portfolio André Farber, Solvay  Financial Economics
Business School Resources on
Theory: 1600-1960, Harry M.
QFINANCE (archived 2014-03-
Markowitz. Financial Analysts  An introduction to
13)
Journal, Vol. 55, No. 4 (Jul. - investment theory,
Aug., 1999), pp. 5-16 Prof. William  Financial Economics Links
Goetzmann, Yale on WebEc (archived 2016-03-24)
 The Theory of Corporate
Finance: A Historical School of Actuarial resources
Overview, Michael C. Jensen and Management
Clifford W. Smith.  Macro-Investment  "Models for Financial
 A Stylized History of Analysis. Economics (MFE)", Society of
Quantitative Finance, Emanuel Prof. William F. Actuaries
Derman Sharpe, Stanford
Graduate School of  "Financial Economics
 Financial Engineering: Some (CT8)", Institute and Faculty of
Tools of the Trade (discusses Business
Actuaries
historical context of derivative  Finance
Theory (MIT  "A Primer In Financial
pricing). Ch 10 in Phelim Economics", S. F. Whelan, D. C.
Boyle and Feidhlim Boyle (2001). OpenCourseWare).
Prof. Andrew Bowie and A. J. Hibbert. British
"Derivatives: The Tools That Actuarial Journal, Volume 8,
Changed Finance". Risk Books Lo, MIT.
Issue 1, April 2002, pp. 27–65.
(June 2001). ISBN 189933288X  Financial
Theory (Open Yale  "Pension Actuary's Guide to
 What We Do Know: The Financial Economics". Gordon
Seven Most Important Ideas in Courses). Prof. John
Geanakoplos, Yale Enderle, Jeremy Gold, Gordon
Finance; What We Do Not Know: Latter and Michael
10 Unsolved Problems in University.
Peskin. Society of
Finance, Richard A.  The Theory of Actuaries and American
Brealey, Stewart Investment at Academy of Actuaries.
Myers and Franklin Allen. the Wayback
 An Overview of Modern Machine (archived
Financial June 21, 2012). Prof.
Economics (MIT Working G.L. Fonseca, New
paper). Chi-fu Huang School for Social
Research
 Introduction to
Financial Economics.
Gordan
Zitkovi, University of
Texas at Austin
 An Introduction
to Asset Pricing
Theory, Junhui
Qian, Shanghai Jiao
Tong University

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