Classification of financial economics

Traditional financial theory has strict constraints on the preference of economic subjects and the probability distribution of financial assets income. These strict constraints lead to a famous theoretical framework, that is, the choice of financial assets by economic entities is mainly based on the mean and variance of asset returns. The theory directly derived from this theoretical framework is the familiar mean-variance analysis of portfolio selection. 1955, M. Markowitz, the father of modern "same fund theorem", first explored modern modern portfolio theory. According to this theory, because the return on investment is uncertain, probability function is usually used to describe the possible results of the return on investment, and the uncertainty of the return on assets, that is, risk, is measured by the deviation between the actual return on assets and the expected return. Based on this concept of income and risk, investors use the decision-making criterion of utility maximization to find the optimal solution of investment decision among all possible investment schemes.

arbitrage pricing theory

The capital asset pricing model reveals the determining mechanism of asset returns (asset pricing) when the capital market reaches equilibrium. However, the model is based on many assumptions, some of which are inconsistent with reality, and some empirical results are contrary to the model. This urges people to establish a new theory of financial economics.

In 1976, Stephen a Ross put forward a new theory of capital-asset balance. This is the second research method of financial economics, which is called arbitrage pricing theory (APt). This theory holds that risk can be generated by several factors, rather than based on one risk factor like CAPM, which is consistent with many empirical results. Moreover, CAPM is a special case of APT, which has fewer assumptions than the former. Therefore, it is generally believed that APT is a better alternative theory of CAPM.

Corporate financing structure theory

The third document of financial economics focuses on the financial structure of companies. On 1956, modigliani and Miller published the Theory of Capital Cost, Corporate Financing and Investment (MM Theorem) in American Economic Review, which marked the formation of modern corporate financing structure theory. The irrelevant results it reveals contradict our traditional thinking. We can even come to the conclusion that there will be no other similar theoretical conclusions in the theory of corporate financing structure that are so different from the conventional thinking. Therefore, MM theorem holds that the company's financing structure and its dividend policy have no influence on the company's value. After all, we generally believe that the financing structure is crucial to the success of the company, and the stock market is quite sensitive to the company's dividend policy.

The importance of the discovery of MM theorem is widely misunderstood. Although MM theorem points out the irrelevance of enterprise financing structure, its more important significance lies in that it implicitly leads people to realize the defects of all models based on the assumption of complete financial market. It not only drives people not to accept the relevant suggestions of corporate financiers, but also points out the defects of the theoretical basis on which these suggestions are based.

Incomplete theory of financial market

The fourth development of financial economics is the study of the incompleteness of financial markets. Since 1990s, information economics has been formally introduced into the study of financial markets and financial systems, which indicates that modern financial economics has entered a new stage of development and is also the latest development achievement of modern financial economics. The literature in this field tries to give up a certain condition in the complete market problem, such as one of the conditions that a single financial creditor's right exists in a series of markets for trading. A fundamental difference between incomplete market hypothesis and complete market problem lies in information asymmetry hypothesis. Because economic agents are allowed to have different information, their related behaviors have changed, and the basic aspects of market transactions have also changed. When the economic subject cannot observe the subject matter of the transaction or the behavior of everyone else in the market, the market transaction becomes quite difficult. The literature on asymmetric information studies the optimal institutional arrangement between willing borrowers and willing borrowers. Here, people who are willing to borrow money and those who are willing to lend receive different information.

The introduction of asymmetric information opens the way for the study of incentive problems. Once both parties to the contract cannot independently observe the information in the financial market at the same cost, then one of them will have a tendency to pretend. By pretending, he induced the other party to make a decision that was contrary to his own interests. This incentive problem destroys the original internal operating mechanism of financial market contracts, and then makes market transactions based on common interest expectations unsustainable. In short, the incentive problem may lead to the closure of the market. At the same time, the incentive problem will stimulate the development of other types of institutional arrangements, and the main function of these institutional arrangements will be to fully absorb and control information problems.