Page 19 - Griffenomics

FACT:

DURING THE FOURTH QUARTER OF 2008, THE OUTPUT OF GOODS AND SERVICES IN THE USA DECREASED AT AN ANNUAL RATE OF 6%

SPRING ISSUE

GRIFFENOMICS

19

values and real values is a core element

in the world of Financial Economics. We

must understand how to value money

eectively before jumping into other as-

pects.

WHAT MAKES FINANCIAL

ECONOMICS SO DISTINCTIVE TO

OTHER BRANCHES OF STUDY?

You have a reasonably sized pot of money

in hand, however, you want to turn this

pot into even more money. You throw

your whole pot into the stock market,

which provides high rates of return. You

act rationally (as any economics text-

book suggests) by buying and selling

stocks that maximise your gains. How-

ever, following a sudden economic shock

in your country, you discover that your

pot of cash has evaporated completely,

and left in its place are nothing but debts

and bankruptcy. Why might this hap-

pen? The answer is fairly simple - risk!

In most ideological economic models

we assume risks don’t occur and every

individual will make their actions ratio-

nally. However, in the real world, where

Financial Economics is concerned, risk

is always the first thing people consider.

The 2008 financial crisis in the United

States is a particularly poignant issue in

the study of Financial Economics. People

at this time were crazy for profit. They

didn’t properly consider the many risks

involved in their actions and this consti-

tuted the start of the collapse of the USA’s

economy. Since Financial Economics

observes the world in an uncertain envi-

ronment, it is necessary to take account

of the risks involved in performing any

economic activity.

WHAT ARE PORTFOLIOS AND

FINANCIAL INSTRUMENTS?

One major study in Financial Economics

is the justification of the value of various

financial assets within a portfolio, based

on the rate of return, time frame, liquid-

ity and potential risk. As seen in real life,

people may encounter lots of dierent

investment combinations. They will val-

ue various assets dierently to other peo-

ple. The case is similar when choosing

dierent meal combinations from a set

three course dinner menu. People will

place dierent values on various types of

food. For example, in many cases, steak

is the most popular option available on

a menu. Hence the value of steak to most

consumers will be high. However, there

may be some customers who are vegetar-

ian. As a result, the value of steak to them

will not be as high. The same theory ap-

plies to the combination of investments

chosen for a portfolio. It is always wise

to view all the dierent types of financial

instruments on oer. They are the major

components of a portfolio.

Stock is perhaps the best known type

of financial asset. It generally provides

fairly high rates of return and a control-

lable time frame. It also involves only a

medium level of risk. Bonds, in contrast,

oer a fixed time contract. However, they

are a relatively safe asset, meaning the

rate of return on them is usually quite

low. In housing markets, mortgages are

another financial asset. This asset can

bring an exceptionally high rate of re-

turn, however the risk incurred is also

very high. This originates from the ex-

tensive speculating behaviour involved

in this market, which acts to drive house

prices higher and higher. Foreign cur-

rencies are an alternative choice for in-

vestors who want to gain an appreciable

return, yet do not want to bare too much

risk. Foreign currencies are not as risky

as mortgages, but they do generate high-

er returns than bonds. Another category

of assets worthmentioning is that of pre-

cious metals. These are usually referred

to as “harbours” against economic crises.

Metals such as gold and silver are un-

doubtedly some of the safest assets peo-

ple can put their pot into, since the price

of themwon’t fluctuate a great deal, even

when an economy faces severe shocks.

They are preferable for people who seek

long-term investments yet do not want to

bear too much risk. A fascinating aspect

of studying Financial Economics is judg-

ing the benefits and costs of all the above

mentioned assets, and in turn determin-

ing a preferred portfolio which maximis-

es the rate of return and minimises the

risks involved as much as possible.

WHAT DO BUBBLES AND

SPECULATION REFLECTS?

The study of Financial Economics can be

used to explain some rather unnatural

behaviours which humans undertake in

the real world. Normally, when people

invest their money they gain profits by

means of interest, dividends or capital

gains. However, everyone is ambitious.

To gain higher profits they make use of

the short-term fluctuations of financial

instruments to earn money. This is es-

sentially how speculation arises. Typi-

cally, the Stock Exchange has numerous

investors who speculate continuously

and repeatedly. As stock prices rise, more

and more investors join the speculation

army. Prices start to rise abnormally and

at an increasingly rapid rate. Bubbles,

which signal an irregular stock price

movement, appear one by one. They are

extremely dangerous. Once the market

experiences a sudden shock, bubbles

may eventually burst and prices start to

collapse. The consequences are devas-

tating and this have been proven by both

the dot-com crisis and the financial crisis

in 2000 and 2008 respectively. The the-

ory of economics assumes that humans

behave rationally and make correct de-

cisions. However, in the real world, ca-

price occurs for most people. Financial

Economists will analyse these factors

comprehensively and make comparisons

between people acting theoretically and

in actual circumstances.

In general, Financial Economics gives

rise to a brand new aspect of economic

study. It gives economists (who rely on

traditional theories and models) a pair of

eyes to view the real market. Therefore,

it is surely worth our while investigating

the principles that lie behind Financial

Economics.