Principles of Financial Economics 2000

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Financial economics plays a far more prominent role in the training of economists than it did even a few years ago. This change is generally attributed to the parallel transformation in capital markets that has occurred in recent years. It is true that trillions of dollars of assets are traded daily in ¯nancial markets|for derivative securities like options and futures, for example|that hardly existed a decade ago. However, it is less obvious how important these changes are. Insofar as derivative securities can be valued by arbitrage, such securities only duplicate primary securities. For example, to the extent that the assumptions underlying the Black-Scholes model of option pricing (or any of its more recent extensions) are accurate, the entire options market is redundant, since by assumption the payo® of an option can be duplicated using stocks and bonds. The same argument applies to other derivative securities markets. Thus it is arguable that the variables that matter most consumption allocations|are not greatly a®ected by the change in capital markets. Along these lines one would no more infer the importance of ¯nancial markets from their volume of trade than one would make a similar argument for supermarket clerks or bank tellers based on the fact that they handle large quantities of cash.

In questioning the appropriateness of correlating the expanding role of ¯nance theory to the explosion in derivatives trading we are in the same position as the physicist who demurs when journalists express the opinion that Einstein's theories are important because they led to the devel-opment of television. Similarly, in his appraisal of John Nash's contributions to economic theory, Myerson [13] protested the tendency of journalists to point to the FCC bandwidth auctions as indicating the importance of Nash's work. At least to those with some curiosity about the phys-ical and social sciences, Einstein's and Nash's work has a deeper importance than television and the FCC auctions! The same is true of ¯nance theory: its increasing prominence has little to do with the expansion of derivatives markets, which in any case owes more to developments in telecommunications and computing than in ¯nance theory.

A more plausible explanation for the expanded role of ¯nancial economics points to the rapid development of the ¯eld itself. A generation ago ¯nance theory was little more than institutional description combined with practitioner-generated rules of thumb that had little analytical basis and, for that matter, little validity. Financial economists agreed that in principle security prices ought to be amenable to analysis using serious economic theory, but in practice most did not devote much e®ort to specializing economics in this direction.Today, in contrast, ¯nancial economics is increasingly occupying center stage in the economic analysis of problems that involve time and uncertainty. Many of the problems formerly analyzed using methods having little ¯nance content now are seen as ¯nance topics. The term structure of interest rates is a good example: formerly this was a topic in monetary economics; now it is a topic in ¯nance.

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The Principles of Economics

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