"There are very few things which we know; which are not capable of being reduc'd to a Mathematical Reasoning; and when they cannot, it's a sign our Knowledge of them is very small and confus'd."
- John Arbuthnot 1692
Introduction
Financial Economics is the study of data, which generates models, which try to understand how and why the financial system works.
The financial system is composed of buyers, sellers and the financial institutions that regulate the rules which govern flows of funds in exchange. We will study concrete examples and simple idealisations of their behaviour.
To provide a context for what will follow, it is useful to consider (if only briefly) the domain of the financial economist.
One of the fundamental aspects of economic activity is a trade in which one party provides another party something, in return for which the second party provides the first something else. In many such trades, or transactions, one or both parties are human beings. If Mr. A gives Ms. B an orange and Ms. B gives Mr. A two apples, it is a trade between two people. In other cases, only one is a human being. If a fisherman throws a fish back in the water to get more fish a year hence, it is a trade between a person and nature. Often the first type of trade is called an exchange, while the second is called production (Sharpe, 1998).
Economists generally (but not always) concern themselves with exchanges in which one of the items traded is money.
To facilitate trade, most societies establish a convention in which a particular item serves as numeraire. Thus if dollars serve as money, one typically trades oranges for apples by (1) trading oranges for dollars ("selling oranges"), then (2) trading dollars for apples ("buying apples"). The terms of the first trade (e.g. €1 for 1 orange) determine the price of an orange (e.g. €1); the terms of the second trade (e.g. €0.50 for one apple) determine the price of an apple (e.g. €0.50). Together, these prices determine the terms of trade for an exchange of oranges for apples (e.g. 1 orange for 2 apples).
The use of money greatly simplifies trading, thus lowering transactions costs. If a society produces 100 different goods, there are 49,950 different possible "good-for-good" trades ([1000x1000-1000]/2). With money, only 1000 prices are needed to establish all possible trading ratios.
Aim
Let's spend some time describing an ideal financial market and the processes inside it, and round out the lecture with a description of the international financial system. Then we can discuss what it says it does, what it really does, and develop some measures to tell when an asset like a stock or a security or something else is doing well, or doing badly.
Length: 1 hour
Lecture notes, slides, and links are below the fold. Just click the link.
Slides
Handout
Further Reading