ECO605 Financial Economics

Lesson 01 INTRODUCTION TO FINANCIAL ECONOMICS

TOPIC 001: INTRODUCTION

Financial economics is a branch of economics that analyzes the use and distribution of resources in markets. Financial decisions must often take into account future events, whether those be related to individual stocks, portfolios, or the market as a whole. Making financial decisions is not always a straightforward process. Time, risk (uncertainty), opportunity costs, and information can create incentives or disincentives. Financial economics employs economic theory to evaluate how certain things impact decision making, providing investors with the instruments to make the right calls.

Financial economics usually involves the creation of sophisticated models to test the variables affecting a particular decision. Often, these models assume that individuals or institutions making decisions act rationally, though this is not necessarily the case. The irrational behavior of parties has to be taken into account in financial economics as a potential risk factor. This branch of economics builds heavily on microeconomics and basic accounting concepts. It is a quantitative discipline that uses econometrics as well as other mathematical tools.

TOPIC 002: FINANCE AND FINANCIAL SYSTEM

Finance is a term for matters regarding the management, creation, and study of money and investments. It involves the use of credit and debt, securities, and investment to finance current projects using future income flows. Because of this temporal aspect, finance is closely linked to the time value of money, interest rates, and other related topics. It is the study of how people allocate scarce resources over time. Allocation of financial decisions are different from other resource allocation decisions

Financial decisions:

1. Spread out over time and
2. Usually not known with certainty in advance by either the decision makers or anybody else.

A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges that permit the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals. The set of markets and other institutions used for financial contracting and the exchange of assets and risks. It includes stocks, bonds and other financial instruments; financial intermediaries such as banks and insurance companies; and regulatory bodies

Multiple components make up the financial system at different levels. The firm's financial system is the set of implemented procedures that track the financial activities of the company. Within a firm, the financial system encompasses all aspects of finances, including accounting measures, revenue and expense schedules, wages, and balance sheet verification. On a regional scale, the financial system is the system that enables lenders and borrowers to exchange funds. Regional financial systems include banks and other institutions, such as securities exchanges and financial clearinghouses.

The global financial system is basically a broader regional system that encompasses all financial institutions, borrowers, and lenders within the global economy. In a global view, financial systems include the International Monetary Fund, central banks, government treasuries and monetary authorities, the World Bank, and major private international banks.

TOPIC 003: WHY STUDY FINANCIAL ECONOMICS?

The study of financial economics helps students understand these forces and provides the tools to assess their impacts. It provides a framework for analyzing how individuals or families, businesses, and governments make decisions as they face trade-offs. To manage your personal resources. To deal with the world of business. To pursue interesting and rewarding career opportunities. To make informed public choices as a citizen. To expand your mind.

TOPIC 004: FINANCIAL DECISIONS

Households and firms have to make financial decisions. The financial decisions of households include: Consumption and saving decisions: How much of the current wealth should they spend on consumption and how much of their current income should they save for the future? Investment decision: How should they invest the money they have saved? Financing decision: When and how should households use other people’s money to implement their consumption and investment plans? Risk-management decision: How and on what terms should households seek to reduce the financial uncertainties they face or when should they increase their risks?

There are four main financial decisions- Capital Budgeting or long-term Investment decision (Application of funds), Capital Structure or Financing decision (Procurement of funds), Dividend decision (Distribution of funds) and Working Capital Management Decision in order to accomplish goal of the firm viz., to maximize shareholder’s (owner’s) wealth.

TOPIC 005: MANAGEMENT AND OWNERSHIP OF A BUSINESS

A sole proprietorship is a business owned by only one person. Advantages include: complete control for the owner, easy and inexpensive to form, and owner gets to keep all of the profits. Disadvantages include: unlimited liability for the owner, complete responsibility for talent and financing, and business dissolves if the owner dies.

A general partnership is a business owned jointly by two or more people. Advantages include: more resources and talents come with an increase in partners, and the business can continue even after the death of a partner. Disadvantages include: partnership disputes, unlimited liability, and shared profits.

A limited partnership has a single general partner who runs the business and is responsible for its liabilities, plus any number of limited partners who have limited involvement in the business and whose losses are limited to the amount of their investment.