3.Financial theory
Financial theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics. Abstractly, finance is concerned with the investment and deployment of assets and liabilities over "space and time"; i.e. it is about performing valuation and asset allocation today, based on risk and uncertainty of future outcomes while appropriately incorporating the time value of money. Determining the present value of these future values, "discounting", must be at the risk-appropriate discount rate, in turn, a major focus of finance-theory. Since the debate as to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance.
Managerial finance is the branch of management that concerns itself with the managerial application of finance techniques and theory, emphasizing the financial aspects of managerial decisions; the discipline assesses these from the managerial perspectives of planning, directing, and controlling. The techniques addressed are drawn in the main from managerial accounting and corporate finance: the former allow management to better understand, and hence act on, financial information relating to profitability and performance; the latter, as above, are about optimizing the overall financial-structure, including its impact on working capital.
Financial economics is the branch of economics that studies the interrelation of financial variables, such as prices, interest rates and shares, as opposed to real economic variables, i.e. goods and services. It thus centers on pricing, decision making and risk management in the financial markets, and produces many of the commonly employed financial models. (Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.)
The discipline has two main areas of focus: asset pricing and (theoretical) corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. Respectively:
Asset pricing theory develops the models used in determining the risk appropriate discount rate, and in pricing derivatives. The analysis essentially explores how rational investors would apply risk and return to the problem of investment under uncertainty. The twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation. At more advanced levels - and often in response to financial crises - the study then extends these "Neoclassical" models to incorporate phenomena where their assumptions do not hold, or to more general settings.
Much of corporate finance theory, by contrast, considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem). Here theory and methods are developed for the decisioning re funding, dividends, and capital structure discussed above. A recent development is to incorporate uncertainty and contingency - and thus various elements of asset pricing - into these decisions, employing for example real options analysis.
Experimental finance aims to establish different market settings and environments to experimentally observe and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion, and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, as well as attempt to discover new principles on which such theory can be extended and be applied to future financial decisions. Research may proceed by conducting trading simulations or by establishing and studying the behavior of people in artificial competitive market-like settings.
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets, and is relevant when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become an integral aspect of finance.
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