Financial economics is a field that blends the study of finance with the methodology of economics. Its practitioners are interested in predicting the individual choices of investors. To do this, they create predictive models based on economic theory that use market conditions as inputs. These models yield predictions for financial factors, including stock prices and interest rates. Financial economics differs from traditional finance in that it recognizes the role of individual investment decisions in contributing to the overarching patterns of financial markets.
Finance is a field concerned with the markets in which financial products are traded. Specialists in finance try to predict fluctuations in financial markets, and they create theories to explain the factors that influence exchange rates, the prices of stocks, derivative markets and other aspects of the financial world. Financial analysts use different approaches to predict the behavior of the financial products they study. For example, some analysts believe that each stock price follows a particular pattern; they graph the past movement of a stock and estimate what the rest of the graph should look like. Others believe in random movements.
Economics is the study of choices. Economists use models to predict how individual actors will behave in certain circumstances, and they observe how closely choices in the real world correspond with the choices their models predict. Then, they adjust their models to account for any discrepancies they see. The factors economists use in models with significant predictive power are the factors that are important in the decisions real world actors make. Once economists have established an effective model, they can use it to see how an event would influence the conditions predicted by the model.
Financial economics addresses the topics covered in the traditional field of finance using an approach consistent with economics. Instead of looking at overall patterns, financial economists think of prices and rates as the products of the accumulated choices of individual investors who decide whether or not to buy or sell. They predict the behavior of financial markets by estimating how various factors will affect the decision-making processes of the investors who participate in the market. Using the equations described by the theories of financial economics, analysts can plug in market factors and find predicted conditions. One example of the applications of financial economics is the Black-Scholes theory of options pricing.