Financial economics

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Financial economics is the branch of economics characterized
by a "concentration on monetary activities", in which "money of
one type or another is likely to appear on both sides of a trade".
[1] Its concern is thus the interrelation of financial variables,
such as prices, interest rates and shares, as opposed to those
concerning the real economy. It has two main areas of focus:
asset pricing (or "investment theory") and corporate finance;
the first being the perspective of providers of capital and the
second of users of capital.

The subject is concerned with "the allocation and deployment

of economic resources, both spatially and across time, in an
uncertain environment".[2] It therefore centers on decision
making under uncertainty in the context of the financial
markets, and the resultant economic and financial models and
principles, and is concerned with deriving testable or policy
implications from acceptable assumptions. It is built on the
foundations of microeconomics and decision theory.

Financial econometrics is the branch of financial economics that

uses econometric techniques to parameterise these
relationships. Mathematical finance is related in that it will
derive and extend the mathematical or numerical models
suggested by financial economics. Note though that the
emphasis there is mathematical consistency, as opposed to
compatibility with economic theory.
Financial economics is usually taught at the postgraduate level;
see Master of Financial Economics. Recently, specialist
undergraduate degrees are offered in the discipline.[3]

Note that this article provides an overview and survey of the

field: for derivations and more technical discussion, see the
specific articles linked.

Contents [hide]
1 Underlying economics
1.1 Present value, expectation and utility
1.2 Arbitrage-free pricing and equilibrium
1.3 State prices
2 Resultant models
2.1 Certainty
2.2 Uncertainty
3 Extensions
3.1 Portfolio theory
3.2 Derivative pricing
3.3 Corporate finance theory
4 Challenges and criticism
4.1 Departures from normality
4.2 Departures from rationality
5 See also
6 References
7 Bibliography
8 External links
Underlying economics[edit]
JEL classification codes
In the Journal of Economic Literature classification codes,
Financial Economics is one of the 19 primary classifications, at
JEL: G. It follows Monetary and International Economics and
precedes Public Economics. For detailed subclassifications see
JEL classification codes #Financial economics JEL: G
Subcategories.
The New Palgrave Dictionary of Economics (2008, 2nd ed.) also
uses the JEL codes to classify its entries in v. 8, Subject Index,
including Financial Economics at pp. 86364. The corresponding
footnotes below have links to entry abstracts of The New
Palgrave Online for each primary or secondary JEL category (10
or fewer per page, similar to Google searches):

JEL:G Financial Economics

JEL: G0 General
JEL: G1 General Financial Markets
JEL: G2 Financial institutions and Services
JEL: G3 Corporate finance and Governance
Tertiary category entries can also be searched.[4]

As above, the discipline essentially explores how rational

investors would apply decision theory to the problem of
investment. The subject is thus built on the foundations of
microeconomics and decision theory, and derives several key
results for the application of decision making under uncertainty
to the financial markets.

Present value, expectation and utility[edit]

Underlying all of financial economics are the concepts of
present value and expectation.[5] Calculating their present
value allows the decision maker to aggregate the cashflows (or
other returns) to be produced by the asset in the future, to a
single value at the date in question, and to thus more readily
compare two opportunities; this concept is therefore the
starting point for financial decision making. Its history is
correspondingly early: Richard Witt discusses compound
interest already in 1613, in his book "Arithmeticall Questions";
[6] further developed by Johan de Witt and Edmond Halley.

An immediate extension is to combine probabilities with

present value, leading to the expected value criterion which
sets asset value as a function of the sizes of the expected
payouts and the probabilities of their occurrence. These ideas
originate with Blaise Pascal and Pierre de Fermat.

This decision method, however, fails to consider risk aversion

("as any student of finance knows" [5]). In other words, since
individuals receive greater utility from an extra dollar when
they are poor and less utility when comparatively rich, the
approach is to therefore "adjust" the weight assigned to the
various outcomes ("states") correspondingly. (Some investors
may in fact be risk seeking as opposed to risk averse, but the
same logic would apply).

Choice under uncertainty here, may then be characterized as

the maximization of expected utility. More formally, the
resulting expected utility hypothesis states that, if certain
axioms are satisfied, the subjective value associated with a
gamble by an individual is that individual's statistical
expectation of the valuations of the outcomes of that gamble.
The impetus for these ideas arise from various inconsistencies
observed under the expected value framework, such as the St.
Petersburg paradox (see also Ellsberg paradox). The
development here originally due to Daniel Bernoulli, and later
formalized by John von Neumann and Oskar Morgenstern.

Arbitrage-free pricing and equilibrium[edit]

The concepts of arbitrage-free "rational" pricing and equilibrium
are then coupled with the above to derive "classical" financial
economics. Rational pricing is the assumption that asset prices
(and hence asset pricing models) will reflect the arbitrage-free
price of the asset, as any deviation from this price will be
"arbitraged away". This assumption is useful in pricing fixed
income securities, particularly bonds, and is fundamental to the
pricing of derivative instruments.

Economic equilibrium is, in general, a state in which economic

forces such as supply and demand are balanced, and, in the
absence of external influences these equilibrium values of
economic variables will not change. General equilibrium deals
with the behavior of supply, demand, and prices in a whole
economy with several or many interacting markets, by seeking
to prove that a set of prices exists that will result in an overall
equilibrium. (This is in contrast to partial equilibrium, which
only analyzes single markets.)

The two concepts are linked as follows: where market prices do

not allow for profitable arbitrage, i.e. they comprise an
arbitrage-free market, then these prices are also said to
constitute an "arbitrage equilibrium". Intuitively, this may be
seen by considering that where an arbitrage opportunity does
exist, then prices can be expected to change, and are therefore
not in equilibrium.[7] An arbitrage equilibrium is thus a
precondition for a general economic equilibrium.

The immediate, and formal, extension of this idea, the

Fundamental theorem of asset pricing, shows that where
markets are as above - and are additionally (implicitly and
correspondingly) complete - one may then make financial
decisions by constructing a risk neutral probability measure
corresponding to the market.

"Complete" here means that there is a price for every asset in

every possible state of the world, and that the complete set of
possible bets on future states-of-the-world can therefore be
constructed with existing assets (assuming no friction),
essentially solving simultaneously for n probabilities, given n
prices. The formal derivation will proceed by arbitrage
arguments.[5][7] For a worked example see Rational
pricing#Risk neutral valuation, where, in a simplified
environment, the economy has only two possible states - up
and down - and where p and (1-p) are the two corresponding
(i.e. implied) probabilities, and in turn, the derived distribution,
or "measure".

With this measure in place, the expected, i.e. required, return of

any security (or portfolio) will then equal the riskless return,
plus an "adjustment for risk",[5] i.e. a security-specific risk
premium, compensating for the extent to which its cashflows
are unpredictable. All pricing models are then essentially
variants of this, given specific assumptions and/or conditions.
[5][8] This approach is consistent with the above, but with the
expectation based on "the market" (i.e. arbitrage-free, and, per
the theorem, therefore in equilibrium) as opposed to individual
preferences.

Thus, continuing the example, to value a specific security, its

forecasted cashflows in the up- and down-states are multiplied
through by p and (1-p) respectively, and are then discounted at
the risk-free interest rate plus an appropriate premium. In
general, this premium may be derived by the CAPM (or
extensions) as will be seen under #Uncertainty.

State prices[edit]
With the above relationship established, the further specialized
ArrowDebreu model may be derived. This important result
suggests that, under certain economic conditions, there must
be a set of prices such that aggregate supplies will equal
aggregate demands for every commodity in the economy. The
analysis here is often undertaken assuming a Representative
agent.
The ArrowDebreu model applies to economies with maximally
complete markets, in which there exists a market for every
time period and forward prices for every commodity at all time
periods. A direct extension, then, is the concept of a state price
security (also called an Arrow-Debreu security), a contract that
agrees to pay one unit of a numeraire (a currency or a
commodity) if a particular state occurs ("up" and "down" in the
simplified example above) at a particular time in the future and
pays zero numeraire in all the other states. The price of this
security is the state price of this particular state of the world.

In the above example, the state prices would equate to the

present values of $p and $(1-p): i.e. what one would pay today,
respectively, for the up- and down-state securities; the state
price vector is the vector of state prices for all states. Applied
to valuation, the price of the derivative today would simply be
[up-state-price up-state-payoff + down-state-price down-
state-payoff]; see below regarding the absence of any risk
premium here. For a continuous random variable indicating a
continuum of possible states, the value is found by integrating
over the state price density; see Stochastic discount factor.
These concepts are extended to Martingale pricing and the
related Risk-neutral measure.

State prices find immediate application as a conceptual tool;[5]

but they can also be applied to valuation problems.[9] Given
the pricing mechanism described, one can decompose the
derivative value as a linear combination of its state-prices, i.e.
back-solve for the state-prices corresponding to observed
derivative prices,[10][9] and these recovered state-prices can
then be used for valuation of other instruments with exposure
to these same states, or for other decision making relating to
this underlyer. (Breeden and Litzenberger's work in 1978 [11]
established the use of state prices in financial economics.)

Resultant models[edit]
ModiglianiMiller Proposition II with risky debt. As leverage (D/E)
increases, the WACC (k0) stays constant.

Efficient Frontier. The hyperbola is sometimes referred to as the

'Markowitz Bullet', and its upward sloped portion is the efficient
frontier if no risk-free asset is available. With a risk-free asset,
the straight line is the efficient frontier. The graphic displays the
CAL, Capital allocation line, formed when the risky asset is a
single-asset rather than the market, in which case the line is
the CML.

The Capital market line is the tangent line drawn from the point
of the risk-free asset to the feasible region for risky assets. The
tangency point M represents the market portfolio. The CML
results from the combination of the market portfolio and the
risk-free asset (the point L). Addition of leverage (the point R)
creates levered portfolios that are also on the CML.
The capital asset pricing model (CAPM)
{\displaystyle E(R_{i})=R_{f}+\beta _{i}(E(R_{m})-R_{f})}
{\displaystyle E(R_{i})=R_{f}+\beta _{i}(E(R_{m})-R_{f})}

Security market line: the representation of the CAPM displaying

the expected rate of return of an individual security as a
function of its systematic, non-diversifiable risk.

Simulated geometric Brownian motions with parameters from

market data.
The BlackScholes equation
{\displaystyle {\frac {\partial V}{\partial t}}+{\frac {1}
{2}}\sigma ^{2}S^{2}{\frac {\partial ^{2}V}{\partial
S^{2}}}+rS{\frac {\partial V}{\partial S}}-rV=0} {\frac
{\partial V}{\partial t}}+{\frac {1}{2}}\sigma ^{2}S^{2}
{\frac {\partial ^{2}V}{\partial S^{2}}}+rS{\frac {\partial V}
{\partial S}}-rV=0
The BlackScholes formula for the value of a call option:
{\displaystyle {\begin{aligned}C(S,t)&=N(d_{1})S-
N(d_{2})Ke^{-r(T-t)}\\d_{1}&={\frac {1}{\sigma {\sqrt {T-
t}}}}\left[\ln \left({\frac {S}{K}}\right)+\left(r+{\frac {\sigma
^{2}}{2}}\right)(T-t)\right]\\d_{2}&=d_{1}-\sigma {\sqrt {T-
t}}\\\end{aligned}}} {\begin{aligned}C(S,t)&=N(d_{1})S-
N(d_{2})Ke^{-r(T-t)}\\d_{1}&={\frac {1}{\sigma {\sqrt {T-
t}}}}\left[\ln \left({\frac {S}{K}}\right)+\left(r+{\frac {\sigma
^{2}}{2}}\right)(T-t)\right]\\d_{2}&=d_{1}-\sigma {\sqrt {T-
t}}\\\end{aligned}}
Applying the preceding economic concepts, we may then derive
various economic- and financial models and principles. As
above, the two usual areas of focus are Asset Pricing and
Corporate Finance, the first being the perspective of providers
of capital, the second of users of capital. Here, and for (almost)
all other financial economics models, the questions addressed
are typically framed in terms of "time, uncertainty, options, and
information",[1] as will be seen below.

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 (FMV).
Applying this framework, with the above concepts, leads to the
required models. This derivation begins with the assumption of
"no uncertainty" and is then expanded to incorporate the other
considerations. (This division sometimes denoted
"deterministic" and "random",[12] or "stochastic".)
Certainty[edit]
A starting point here is Investment under certainty". The Fisher
separation theorem, asserts that the objective of a corporation
will be the maximization of its present value, regardless of the
preferences of its shareholders. Related is the Modigliani-Miller
theorem, which shows that, under certain conditions, the value
of a firm is unaffected by how that firm is financed, and
depends neither on its dividend policy nor its decision to raise
capital by issuing stock or selling debt. The proof here proceeds
using arbitrage arguments, and acts as a benchmark for
evaluating the effects of factors outside the model that do
affect value.

The mechanism for determining (corporate) value is provided

by The Theory of Investment Value (John Burr Williams), which
proposes that the value of an asset should be calculated using
evaluation by the rule of present worth. Thus, for a common
stock, the intrinsic, long-term worth is the present value of its
future net cashflows, in the form of dividends. What remains to
be determined is the appropriate discount rate. Later
developments show that, "rationally", i.e. in the formal sense,
the appropriate discount rate here will (should) depend on the
asset's riskiness relative to the overall market, as opposed to
its owners' preferences; see below. (Net present value (NPV), a
direct extension of these ideas, was first formally applied to
Corporate Finance decisioning by Joel Dean in 1951).

Bond valuation, in that cashflows (coupons and return of

principal) are deterministic, may proceed in the same fashion.
[12] An immediate extension, Arbitrage-free bond pricing,
discounts each cashflow at the market derived rate i.e. at
each coupon's corresponding zero-rate as opposed to an
overall rate.

Note that in many treatments bond valuation precedes equity

valuation, where cashflows (dividends) are not "known" per se.
Williams and onward allow for forecasting assumptions - based
on historic ratios or published policy - as to these, and
cashflows are then treated as essentially deterministic; see
below under #Corporate finance theory.

These "certainty" results are all commonly employed under

corporate finance; uncertainty is the focus of "asset pricing
models", as follows.

Uncertainty[edit]
For "choice under uncertainty", the twin assumptions of
rationality and market efficiency lead to modern portfolio
theory (MPT) with its Capital asset pricing model (CAPM) an
equilibrium-based result and to the BlackScholesMerton
theory (BSM; often, simply Black-Scholes) for option pricing
an arbitrage-free result.

Briefly, and intuitively - and consistent with #Arbitrage-free

pricing and equilibrium above - the linkage is as follows.[13]
Given the ability to profit from private information, self-
interested traders are motivated to acquire and act on their
private information. In doing so, traders contribute to more and
more efficient market prices: the Efficient Market Hypothesis
(EMH). The EMH (implicitly) assumes that average expectations
constitute an "optimal forecast", i.e. prices using all available
information, are identical to the best guess of the future: the
assumption of rational expectations. The EMH does allow that
when faced with new information, some investors may
overreact and some may underreact, but what is required,
however, is that investors' reactions follow a normal distribution
- so that the net effect on market prices cannot be reliably
exploited to make an abnormal profit. In the competitive limit,
then, market prices will reflect all available information and
prices can only move in response to news:[14] the random walk
hypothesis. Thus, if prices of financial assets are (broadly)
correct, i.e. efficient, then deviations from these (equilibrium)
values could not last for long.

Under these conditions investors can then be assumed to act

rationally: their investment decision must be calculated or a
loss is sure to follow. Also, where an arbitrage opportunity
presents itself, then investors will exploit it, reinforcing this
equilibrium. Here, as under the certainty-case above, the
specific assumption as to pricing is that prices are calculated as
the present value of expected future dividends,[8][14] as based
on currently available information. What is required though is a
theory for determining the appropriate discount rate given this
uncertainty: this is provided by the MPT and its CAPM.
Relatedly, rationality in the sense of arbitrage-exploitation
gives rise to Black-Scholes; option values here ultimately
consistent with the CAPM.

In general, then, while portfolio theory studies how investors

should balance risk and return when investing in many assets
or securities, the CAPM is more focused, describing how, in
equilibrium, markets set the prices of assets in relation to how
risky they are. Importantly, this result will be independent of
the investor's level of risk aversion, and / or assumed utility
function, thus providing a readily determined discount rate for
corporate finance decision makers as above,[15] and for other
investors. The argument proceeds as follows: If one can
construct an efficient frontier i.e. each combination of assets
offering the best possible expected level of return for its level of
risk, see diagram then mean-variance efficient portfolios can
be formed simply as a combination of holdings of the risk-free
asset and the "market portfolio" (the Mutual fund separation
theorem), with the combinations here plotting as the capital
market line, or CML. Then, given this CML, the required return
on risky securities will be independent of the investor's utility
function, and solely determined by their covariance with
aggregate, i.e. market, risk (beta). As seen in the formula
aside, this result is consistent with the preceding, equaling the
riskless return plus an adjustment for risk.[8] (The efficient
frontier was introduced by Harry Markowitz. The CAPM was
derived by Jack Treynor (1961, 1962), William F. Sharpe (1964),
John Lintner (1965) and Jan Mossin (1966) independently.)

Black-Scholes provides a mathematical model of a financial

market containing derivative instruments, and the resultant
formula for the price of European-styled options. The model is
expressed as the BlackScholes equation, a partial differential
equation describing the changing price of the option over time;
it is derived assuming log-normal, geometric Brownian motion.
The key financial insight behind the model is that one can
perfectly hedge the option by buying and selling the underlying
asset in just the right way and consequently "eliminate risk",
absenting the risk adjustment from the pricing ( {\displaystyle
V} V, the value, or price, of the option, grows at {\displaystyle
r} r, the risk-free rate; see BlackScholes equation#Financial
interpretation).[5][8] This hedge, in turn, implies that there is
only one right price in an arbitrage-free sense for the
option. And this price is returned by the BlackScholes option
pricing formula. (The formula, and hence the price, is consistent
with the equation, as the formula is the solution to the
equation.) Since the formula is without reference to the share's
expected return, Black-Scholes entails (assumes) risk
neutrality, consistent with the "elimination of risk" here.
Relatedly, therefore, the pricing formula may also be derived
directly via risk neutral expectation; see Brownian model of
financial markets. (BSM is consistent with "previous versions of
the formula" of Louis Bachelier and Edward O. Thorp.[16] See
also Paul Samuelson (1965). [17])

As mentioned, it can be shown that the two models are

consistent; then, as is to be expected, "classical" financial
economics is thus unified. Here, the Black Scholes equation
may alternatively be derived from the CAPM, and the price
obtained from the Black-Scholes model is thus consistent with
the expected return from the CAPM.[18] The Black-Scholes
theory, although built on Arbitrage-free pricing, is therefore
consistent with the equilibrium based capital asset pricing. Both
models, in turn, are ultimately consistent with the Arrow-
Debreu theory, and may be derived via state-pricing,[5] further
explaining, and if required demonstrating, this unity.

Extensions[edit]
More recent work further generalizes and / or extends these
models.

Portfolio theory[edit]

Plot of two criteria when maximizing return and minimizing risk

in financial portfolios (Pareto-optimal points in red)
See also: Post-modern portfolio theory; Mathematical
finance#Risk and portfolio management: the P world.
The majority of developments here relate to required return,
extending the basic CAPM. Multi-factor models such as the
FamaFrench three-factor model and the Carhart four-factor
model, propose factors other than market return as relevant in
pricing. The Intertemporal CAPM and Consumption-based CAPM
similarly extend the model. With intertemporal portfolio choice,
the investor now repeatedly optimizes her portfolio; while the
inclusion of consumption (in the economic sense) then
incorporates all sources of wealth, and not just market-based
investments, into the investor's calculation of required return.

Whereas the above extend the CAPM, the single-index model is

a more simple model. It assumes, only, a correlation between
security and market returns, without (numerous) other
economic assumptions. It is useful in that it simplifies the
estimation of correlation between securities, significantly
reducing the inputs for building the correlation matrix required
for portfolio optimization. The arbitrage pricing theory (APT)
similarly differs as regards its assumptions. Instead of assuming
equilibrium, it returns the required (expected) return of a
financial asset as a linear function of various macro-economic
factors, and assumes that arbitrage should bring incorrectly
priced assets back into line.

As regards Portfolio optimization, the BlackLitterman model

departs from the original Markowitz approach of constructing
portfolios via an efficient frontier. BlackLitterman instead starts
with an equilibrium assumption, and is then modified to take
into account the 'views' (i.e., the specific opinions about asset
returns) of the investor in question to arrive at a bespoke asset
allocation. Where factors additional to volatility are considered
(kurtosis, skew...) then multiple-criteria decision analysis can be
applied; here deriving a Pareto efficient portfolio. The universal
portfolio algorithm (Thomas M. Cover) applies machine learning
to asset selection, learning adaptively from historical data. See
also Portfolio optimization#Improving portfolio optimization for
other techniques and / or objectives.

Derivative pricing[edit]

Binomial Lattice with CRR formulae

See also: Mathematical finance#Derivatives pricing: the Q
world.
As regards derivative pricing, the binomial options pricing
model provides a discretized version of Black-Scholes, useful
for the valuation of American styled options. Discretized models
of this type are built - at least implicitly - using state-prices (as
above); relatedly, a large number of researchers have used
options to extract state-prices for a variety of other applications
in financial economics.[5][18][10] For path dependent
derivatives, Monte Carlo methods for option pricing are
employed; here the modelling is in continuous time, but
similarly uses risk neutral expected value. Various other
numeric techniques have also been developed. The theoretical
framework too has been extended such that martingale pricing
is now the standard approach. Developments relating to
complexities in return and / or volatility are discussed below.
Drawing on these techniques, derivative models for various
other underlyings and applications have also been developed,
all based on the same logic. Real options valuation allows that
option holders can influence the option's underlying; models for
employee stock option valuation explicitly assume non-
rationality on the part of option holders; Credit derivatives allow
that payment obligations and / or delivery requirements might
not be honored. Exotic derivatives are now routinely valued.

Similarly, beginning with Oldrich Vasicek, various short rate

models, as well as the HJM and BGM forward rate-based
techniques, allow for an extension of these to fixed income- and
interest rate derivatives. (The Vasicek and CIR models are
equilibrium-based, while HoLee and subsequent models are
based on arbitrage-free pricing.) Bond valuation is relatedly
extended: the Stochastic calculus approach, employing these
methods, allows for rates that are "random" (while returning a
price that is arbitrage free, as above); Lattice models for Hybrid
Securities allow for non-deterministic cashflows (and stochastic
rates).

As above, (OTC) derivative pricing has relied on the BSM risk

neutral pricing framework, under the assumptions of funding at
the risk free rate and the ability to perfectly replicate
derivatives so as to fully hedge. This, in turn, is built on the
assumption of a credit-risk-free environment. Post the financial
crisis of 2008, therefore, issues such as counterparty credit risk,
funding costs and costs of capital are considered,[19] and a
Credit Valuation Adjustment, or CVA - and potentially other
valuation adjustments, collectively xVA - is generally added to
the derivative value as calculated. Swap pricing is relatedly and
further modified. Previously, swaps were valued off a single
"self discounting" interest rate curve; while post crisis, to
accommodate credit risk, valuation is now under a "multi-
curve" framework; see Interest rate swap #Valuation and
pricing.
Corporate finance theory[edit]

Project valuation via decision tree.

Corporate finance theory has also been extended: mirroring the
above developments, asset-valuation and decisioning no longer
need assume "certainty". As discussed, Monte Carlo methods in
finance, introduced by David B. Hertz in 1964, allow financial
analysts to construct "stochastic" or probabilistic corporate
finance models, as opposed to the traditional static and
deterministic models;[20] see Corporate finance#Quantifying
uncertainty. Relatedly, Real Options theory allows for owner -
i.e. managerial - actions that impact underlying value: by
incorporating option pricing logic, these actions are then
applied to a distribution of future outcomes, changing with
time, which then determine the "project's" valuation today.[21]

More traditionally, decision trees - which are complementary -

have been used to evaluate projects, by incorporating in the
valuation (all) possible events (or states) and consequent
management decisions.[20] (This technique predates the use of
real options in corporate finance; it is borrowed from operations
research, and is not a "financial economics development" per
se.) Related to this, is the treatment of forecasted cashflows in
equity valuation. In many cases, following Williams above, the
"most likely" cash-flows were discounted, as opposed to a more
correct state-by-state treatment under uncertainty; see
comments under Financial modeling#Accounting. In more
modern treatments, then, it is the expected cashflows (in the
mathematical sense) combined into an overall value per
forecast period which are discounted. [22][23][20] (And using
the CAPM - or extensions - the discounting here is at the risk-
free rate plus a premium linked to the uncertainty of the
entity's cash flows.)
Other extensions here include [24] agency theory, which
analyses the difficulties in motivating corporate management
(the "agent") to act in the best interests of shareholders (the
"principal"), rather than in their own interests. Clean surplus
accounting and the related residual income valuation provide a
model that returns price as a function of earnings, expected
returns, and change in book value, as opposed to dividends.
This approach, to some extent, arises due to the implicit
contradiction of seeing value as a function of dividends, while
also holding that dividend policy cannot influence value per
Modigliani and Millers Irrelevance principle; see Dividend
policy#Irrelevance of dividend policy.

The typical application of real options is to capital budgeting

type problems as described. However, they are also applied to
questions of capital structure and dividend policy, and to the
related design of corporate securities; and since stockholder
and bondholders have different objective functions, in the
analysis of the related agency problems.[21] In all of these
cases, state-prices can provide the market-implied information
relating to the corporate, as above, which is then applied to the
analysis. For example, convertible bonds can (must) be priced
consistent with the state-prices of the corporate's equity.[9]

Challenges and criticism[edit]

See also: Financial mathematics#Criticism; Financial
engineering#Criticisms; Financial Modelers' Manifesto;
Unreasonable ineffectiveness of mathematics#Economics and
finance; Physics envy; as well as [25]
As above, there is a very close link between the random walk
hypothesis, with the associated expectation that price changes
should follow a normal distribution, on the one hand, and
market efficiency and rational expectations, on the other. Note,
however, that (wide) departures from these are commonly
observed, and there are thus, respectively, two main sets of
challenges.
Departures from normality[edit]

Implied volatility surface. The Z-axis represents implied

volatility in percent, and X and Y axes represent the option
delta, and the days to maturity.
See also: Capital asset pricing model#Problems of CAPM;
Modern portfolio theory#Criticisms; BlackScholes
model#Criticism.
The first set of challenges: As discussed, the assumptions that
market prices follow a random walk and / or that asset returns
are normally distributed are fundamental. Empirical evidence,
however, suggests that these assumptions may not hold (see
Kurtosis risk, Skewness risk, Long tail) and that in practice,
traders, analysts and risk managers frequently modify the
"standard models" (see Model risk). In fact, Benot Mandelbrot
had discovered already in the 1960s that changes in financial
prices do not follow a Gaussian distribution, the basis for much
option pricing theory, although this observation was slow to
find its way into mainstream financial economics.

Financial models with long-tailed distributions and volatility

clustering have been introduced to overcome problems with the
realism of the above classical financial models; while jump
diffusion models allow for (option) pricing incorporating "jumps"
in the spot price. Risk managers, similarly, complement (or
substitute) the standard value at risk models with historical
simulations, mixture models, principal component analysis,
extreme value theory, as well as models for volatility clustering.
[26] For further discussion see Fat-tailed
distribution#Applications in economics, and Value at
risk#Criticism.

Closely related is the volatility smile, where implied volatility -

the volatility corresponding to the BSM price - is observed to
differ as a function of strike price (i.e. moneyness), true only if
the price-change distribution is non-normal, unlike that
assumed by BSM. The term structure of volatility describes how
(implied) volatility differs for related options with different
maturities. An implied volatility surface is then a three-
dimensional surface plot of volatility smile and term structure.
These empirical phenomena negate the assumption of constant
volatility and log-normality upon which Black-Scholes is
built;[16] see BlackScholes model#The volatility smile.

Approaches developed here in response include local volatility

and stochastic volatility (the Heston, SABR and CEV models,
amongst others). Alternatively, implied-binomial and -trinomial
trees instead of directly modelling volatility, return a lattice
consistent with observed prices in an arbitrage-free sense
(essentially recovering state-prices, as described above)
facilitating the pricing of other, i.e. non-quoted, strike/maturity
combinations. Edgeworth binomial trees allow for a specified
(i.e. non-Gaussian) skew and kurtosis in the spot price. Priced
here, options with differing strikes will return differing implied
volatilities, and the tree can thus be calibrated to the smile if
required.[27] Similarly purposed closed-form models include:
Jarrow and Rudd (1982); Corrado and Su (1996); Backus, Foresi,
and Wu (2004).[28]

As above, additional to log-normality in returns, BSM assumes

the ability to perfectly replicate derivatives so as to fully hedge,
and hence to discount at the risk-free rate. This, in turn, is built
on the assumption of a credit-risk-free environment. The post
crisis reality, however, differs, necessitating the various xVA
adjustments to the derivative valuation, as described. Note that
these adjustments are additional to any smile or surface effect.
This is valid as the surface is built on price data relating to fully
collateralized positions, and there is therefore no "double
counting" of credit risk (etc.) when including xVA. (Also, were
this not the case, then each counterparty would have its own
surface...)
Departures from rationality[edit]
Market anomalies and Economic puzzles
Calendar effect
January effect
Santa Claus rally
Sell in May
Closed-end fund puzzle
Dividend puzzle
Equity home bias puzzle
Equity premium puzzle
Forward premium anomaly
Low-volatility anomaly
Momentum anomaly
Post-earnings-announcement drift
Real exchange-rate puzzles
See also: Efficient-market hypothesis#Criticism and behavioral
finance; Rational expectations#Criticisms.
The second set of challenges: As seen, a common assumption
is that financial decision makers act rationally; see Homo
economicus. Recently, however, researchers in experimental
economics and experimental finance have challenged this
assumption empirically. These assumptions are also challenged
theoretically, by behavioral finance, a discipline primarily
concerned with the limits to rationality of economic agents.

Consistent with, and complementary to these findings, various

persistent market anomalies have been documented, these
being price and/or return distortions - e.g. size premiums -
which appear to contradict the efficient-market hypothesis;
calendar effects are the best known group here. Related to
these are various of the economic puzzles, concerning
phenomena similarly contradicting the theory. The equity
premium puzzle, as one example, arises in that the difference
between the observed returns on stocks as compared to
government bonds is consistently higher than the risk premium
rational equity investors should demand, an "abnormal return".
For further context see Random walk hypothesis#A non-
random walk hypothesis, and sidebar for specific instances.

More generally, and particularly following the financial crisis of

20072010, financial economics and mathematical finance
have been subjected to deeper criticism; notable here is
Nassim Nicholas Taleb, who claims that the prices of financial
assets cannot be characterized by the simple models currently
in use, rendering much of current practice at best irrelevant,
and, at worst, dangerously misleading; see Black swan theory,
Taleb distribution. A topic of general interest studied in recent
years has thus been financial crises,[29] and the failure of
financial economics to model these.

Areas of research attempting to explain (or at least model)

these phenomena, and crises, include noise trading, market
microstructure, and Heterogeneous agent models. The latter is
extended to agent-based computational economics, where
price is treated as an emergent phenomenon, resulting from
the interaction of the various market participants (agents). The
noisy market hypothesis argues that prices can be influenced
by speculators and momentum traders, as well as by insiders
and institutions that often buy and sell stocks for reasons
unrelated to fundamental value; see Noise (economic). The
adaptive market hypothesis is an attempt to reconcile the
efficient market hypothesis with behavioral economics, by
applying the principles of evolution to financial interactions. An
information cascade, alternatively, shows market participants
engaging in the same acts as others ("herd behavior"), despite
contradictions with their private information. See also Hyman
Minsky's "financial instability hypothesis", as well as George
Soros' approach, #Reflexivity, financial markets, and economic
theory.
Note however, that on the obverse, various studies have shown
that despite these departures from efficiency, asset prices do
typically exhibit a random walk and that one cannot therefore
consistently outperform market averages.[30] The practical
implication, therefore, is that passive investing (e.g. via low-
cost index funds) should, on average, serve better than any
other active strategy.[31] Burton Malkiel's A Random Walk
Down Wall Street - first published in 1973, and in its 11th
edition as of 2015 - is a widely read popularization of these
arguments. (See also John C. Bogles Common Sense on Mutual
Funds; but compare Warren Buffett's The Superinvestors of
Graham-and-Doddsville.) Note also that institutionally inherent
limits to arbitrage as opposed to factors directly
contradictory to the theory are sometimes proposed as an
explanation for these departures from efficiency.