Financial economics applies the techniques of economic analysis to understand the
savings and investment decisions by individuals, the investment, financing and payout
decisions by firms, the level and properties of interest rates and prices of financial
assets and derivatives, and the economic role of financial intermediaries. Until the
1950s, finance was viewed primarily as the study of financial institutional detail and
was hardly accorded the status of a mainstream field of economics. This perception
was epitomized by the difficulty Harry Markowitz had in receiving a PhD degree in
the economics department at the University of Chicago for work that eventually would
earn him a Nobel prize in economic science. This state of affairs changed in the second
half of the 20th century with a revolution that took place from the 1950s to the early
1970s. At that time, key progress was made in understanding the financial decisions
of individuals and firms and their implications for the pricing of common stocks, debt,
and interest rates.
Harry Markowitz, William Sharpe, James Tobin, and others showed how individuals
concerned about their expected future wealth and its variance make investment
decisions. Their key results showing the benefits of diversification, that wealth is
optimally allocated across funds that are common across individuals, and that investors
are rewarded for bearing risks that are not diversifiable, are now the basis for much of
the investment industry. Merton Miller and Franco Modigliani showed that the concept
of arbitrage is a powerful tool to understand the implications of firm capital structures
for firm value. In a world without frictions, they showed that a firm’s value is unrelated
to its capital structure. Eugene Fama put forth the efficient markets hypothesis and led
the way in its empirical investigation. Finally, Fischer Black, Robert Merton and Myron
Scholes provided one of the most elegant theories in all of economics: the theory of
how to price financial derivatives in markets without frictions.