This topic will cover the basic concepts of financial theory, including the time value of money, risk and return, financial markets, and the role of financial institutions in the economy.
Introduction to Financial Theory
Key concepts, foundational models, and the logical framework that underpins modern finance.
| Aspect | Description |
|---|---|
| Definition | A systematic body of ideas that explains how financial markets work, how assets are priced, and how individuals and firms make optimal financial decisions. |
| Goal | Explain observed market behavior, predict future outcomes, and provide a basis for sound financial decision‑making. |
| Scope | • Asset pricing (stocks, bonds, derivatives) • Portfolio selection • Capital structure • Market efficiency • Risk management • Behavioral anomalies |
| Assumption | Typical Formulation | Implication |
|---|---|---|
| Rational agents | Investors maximize expected utility. | Choices are consistent with risk‑return trade‑off. |
| Efficient markets | Prices fully reflect all available information. | No systematic arbitrage opportunities. |
| Homogeneous expectations | All investors share the same probability beliefs about future cash flows. | Leads to a unique equilibrium price. |
| Frictionless trading | No taxes, transaction costs, or short‑sale restrictions. | Allows continuous rebalancing of portfolios. |
| Divisible assets | Securities can be bought in any quantity. | Enables precise portfolio construction. |
| Risk‑free borrowing/lending | Exists a security with a certain return (r_f). | Provides a baseline for measuring risk premiums. |
Real‑world finance relaxes many of these assumptions; extensions (e.g., behavioral finance, market microstructure) address the gaps.