Models in Financial Economics
Financial economics is primarily concerned with building models to derive testable or policy implications from acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect value.
A common assumption is that financial decision makers act rationally (see Homo economicus; efficient market hypothesis). However, recently, researchers in experimental economics and experimental finance have challenged this assumption empirically. They are also challenged, theoretically, by behavioral finance, a discipline primarily concerned with the limits to rationality of economic agents.
Other common assumptions include market prices following a random walk or asset returns being normally distributed. Empirical evidence suggests that these assumptions may not hold and that in practice, traders, analysts and particularly risk managers frequently modify the "standard models".
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