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• Time: money now is traded for money in the future.
• Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
• Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
• Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value.

Financial economics attempts to answer questions such as:

• How are the prices of financial assets, such as stocks and bonds, determined?
• What are the effects of a company choosing different methods of financing its operations, such as issuing shares or borrowing?
• What portfolio of assets should an investor hold in order to best meet his/her objectives?

In recent decades, a lot of work has concerned itself with the prices of derivative securities, financial instruments that derive their value from other, underlying, assets. Stock options are a classic form of derivative -- Fischer Black, Myron S. Scholes, and Robert C. Merton did ground-breaking work in the early 1970sMillennia: 1st millennium 2nd millennium 3rd millennium Centuries: 19th century 20th century 21st century Decades: 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010s 2020s Years: 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Events and trends on the determination of stock optionA stock option is a specific type of option with a stock as the underlying instrument (the security that the value of the option is based on). Thus it is a contract to buy (known as a " call" contract) or sell (known as a " put" contract) shares of stock, prices on the basis of the underlying stock's price and volatilityVolatility is the standard deviation of the change in value of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms, and i.

The work soon proved to have widespread applications, and helped inspire the creation of ever more complicated derivatives, (swaps, swaptions, etc.) which in turn has kept theorists busy building newer models.

The underlying point behind all the model construction is that of finding a value that arbitrageIn economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. will enforce. Arbitrage is always a self-terminating activity -- it brings prices to a level at which it can no longer occur. At a certain useful level of abstraction, arbitrage is said to terminate so quickly that it never happens at all, even if some traders do have private information. See no-trade theoremThe no-trade theorem is a result in financial economics demonstrated by Paul Milgrom and Nancy Stokey in a 1982 paper. It states that if markets are in a state of efficient equilibrium, if there are no noisy traders or other nonrational interferences with. But real markets have various sorts of friction that inhibit that ideal operation.

Important concepts: Risk free rate, Time value of money, Fisher separation theorem, Modigliani-Miller theorem, Arbitrage, Rational pricing, Efficient markets theory, Modern portfolio theory

See also: Finance, Financial mathematics, Mathematical economics, Model (economics)

References: Professor William Sharpe:"Macro-Investment Analysis"

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