Financial economics is a branch of economics that analyzes the distribution and use of resources in markets in which decisions are made under uncertainty. Financial decisions must often take into account future events, whether those are related to individual stocks, portfolios or the market as a whole. The subject is concerned with the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment. It, therefore, centres on decision-making under uncertainty in the context of financial markets. It is built on the foundations of microeconomics and decision theory. Financial economics is important in making investment decisions, identifying risks, and valuing securities and assets. It relies heavily on microeconomics and basic accounting concepts. In addition, it requires familiarity with basic statistics and probability since these are the standard tools used to measure and evaluate risk. Financial economics employs economic theory to evaluate how time, risk, opportunity costs and information can create incentives or disincentives for a particular decision. Financial economics often involves the creation of sophisticated models to test variables affecting a particular decision. Often, these models assume that individuals or institutions making decisions act rationally, though this is not necessarily the case. Irrational behaviour of parties has to be taken into account in financial economics as a potential risk factor. This book provides a comprehensive description of the theory and functioning of financial economics (or economics of finance). It is spread over 28 chapters which have been organized into 5 theme parts. Part I (chapters 1 and 2) is titled Basics of Financial Economics. It gives a bird’s eye view of financial system, financial economics, financial institutions, financial markets and financial instruments. Part II (chapters 3 to 10) is titled Investment Theory and Portfolio Analysis. It deals with discussion on theory of the rate of interest, reasons for interest rate differentials, term structure of interest rates and yield curves, portfolio of assets, mean-variance portfolio analysis, Markowitz model, capital asset pricing model (CAPM), capital market line (CML) and security market line (SML). Part III (chapters 11 to 17) is titled Derivatives, Forwards, Futures and Options. It covers emergence and popularity of financial derivatives, forward contracts, future contracts, options, Black-Scholes-Merton option pricing model, binomial option pricing model, and principles of arbitrage. Part IV (chapters 18 to 22) is titled Corporate Finance. It focuses on the patterns of corporate financing, capital structure and the cost of capital, corporate debt, dividend policy models, and Modigliani-Miller theorem. Part V (chapters 23 to 28) is titled Indian Financial System. It delves into financial institutions, financial markets, financial instruments, financial inclusion, financial regulators, and legislative and institutional measures to strengthen financial sector in India. CONTENTS Part I: Basics of Financial Economics 1. Financial System and Financial Economics 1.1 Meaning and Importance of Financial System 1.2 Functions of Financial System 1.3 Role of the State in Financial Development 1.4 Determinants of Access to Financial Services 1.5 Financial Neutrality versus Financial Activism 1.6 Financial Volatility versus Financial Stability 1.7 Regulation and Supervision of Financial System 1.8 Meaning and Significance of Financial Economics 1.9 Aspects of Financial Economics 2. Financial Institutions, Financial Markets and Financial Instruments 2.1 Financial Institutions 2.2 Financial Markets 2.3 Financial Instruments Part II: Investment Theory and Portfolio Analysis 3. Theory of the Rate of Interest 3.1 Significance of Interest Rate 3.2 Types of Rate of Interest 3.3 Loanable Fund Theory of the Rate of Interest 3.4 Liquidity Preference Theory of the Rate of Interest 4. Reasons for Interest Rate Differentials 4.1 How Are Interest Rates Determined? 4.2 What is an Interest Rate Differential? 4.3 Causes of Differences in Interest Rates 4.4 Types of Credit (Loans) 5. Term Structure of Interest Rates and Yield Curves 5.1 What is Term Structure of Interest Rates? 5.2 Shapes and Uses of Yield Curve 5.3 Three Theories to Explain Yield Curve 5.4 Fixed Income Securities 6. Portfolio of Assets 6.1 Portfolio Defined 6.2 Portfolio Manager 6.3 Portfolio Management 6.4 Diversification of Portfolio 6.5 Efficient Portfolio and Risk Categories 6.6 Problems with Diversification 7. Mean-Variance Portfolio Analysis 7.1 Importance of Portfolio Theory 7.2 What is Mean-Variance Analysis? 7.3 Investment Strategy 7.4 Main Components of Mean-Variance Analysis 7.5 Assumptions of Mean-Variance Analysis 7.6 Calculation of Expected Return and Variance 7.7 Criticism 8. Markowitz Model 8.1 Assumptions 8.2 Markowitz Efficient Set 8.3 Markowitz Efficient Frontier 8.4 Limitations of the Markowitz Model 9. Capital Asset Pricing Model (CAPM) 9.1 Risk and Return 9.2 Systematic Risks versus Unsystematic Risks 9.3 Risk-Return Trade-off 9.4 CAMP Formula 9.5 Assumptions of CAMP 9.6 Limitations of CAPM 9.7 Consumption Capital Asset Pricing Model (CCAPM) 9.8 Inter-temporal Capital Asset Pricing Model (ICAMP) 10. Capital Market Line (CML) and Security Market Line (SML) 10.1 Capital Market Line (CML) 10.2 Security Market Line (SML) Part III: Derivatives, Forwards, Futures and Options 11. Financial Derivatives: Emergence and Popularity 11.1 Emergence of Complex Financial Products 11.2 Meaning of Derivatives 11.3 Reasons for the Popularity of Derivatives 11.4 Variants (or Types) of Derivative Contracts 11.5 Participants in the Derivatives Market 11.6 Economic Role of Derivatives 11.7 History of Derivatives 11.8 International Experience of Derivatives 12. Forward Contracts (or Forwards) 12.1 What is a Forward Contact? 12.2 Salient Features of Forward Contracts 12.3 Example of a Forward Contract 12.4 Advantages of Forwards 12.5 Problems of Forward Contracts 12.6 Risks with Forward Contracts 12.7 Forward Markets Commission (FMC) of India 13. Future Contracts (or Futures) 13.1 What is a Future Contract? 13.2 History of Futures 13.3 How Do Future Contracts Work? 13.4 Hedgers and Speculators 13.5 Role of Clearing House 13.6 Currency Futures 13.7 Distinction between Forwards and Futures 13.8 Introduction of Futures in India 14. Options 14.1 What is an Option? 14.2 Options in Historical Perspective 14.3 Call Options 14.4 Put Options 14.5 Example of an Option 14.6 Advantages of Option Trading 14.7 Forms of Option Trading 14.8 Valuation Models 14.9 Options Risk Metrics: The Greeks 15. Black-Scholes-Merton Option Pricing Model 15.1 What is Black-Scholes Model? 15.2 Basics of the Black-Scholes Model 15.3 Assumptions of Black-Scholes Model 15.4 Black-Scholes Formula 15.5 Limitations of the Black-Scholes Model 16. Binomial Option Pricing Model 16.1 What is Binomial Option Pricing Model (BOPM)? 16.2 Basics of the BOPM 16.3 Assumptions of BOPM 16.4 Calculating Price with the Binomial Model 16.5 Option Valuation 16.6 Advantages and Disadvantages of BOPM 17. Principles of Arbitrage 17.1 What is Arbitrage? 17.2 Conditions for Arbitrage 17.3 Risks Involved in Arbitrage 17.4 Types of Arbitrage 17.5 Arbitrage Pricing Theory (APT) Part IV: Corporate Finance 18. Patterns of Corporate Financing 18.1 Meaning of Corporate Financing 18.2 Sources of Capital 18.3 Capital Investments 19. Capital Structure and the Cost of Capital 19.1 Capital Structure Defined 19.2 Cost of Capital 20. Corporate Debt 20.1 What is Debt? 20.2 Need for Corporate Debt 20.3 Corporate Bonds 20.4 Emergence of Private Placement Market 20.5 Other Types of Corporate Debt 20.6 Significance of the Corporate Debt Market 20.7 Lessons from East Asian Crisis 21. Dividend Policy Models 21.1 Dividend Policy Explained 21.2 Types of Dividend Policy 21.3 Dividend Irrelevance Theories 21.4 Dividend Relevance Theories 22. Modigliani-Miller Theorem (M&M Theorem) 22.1 Historical Background 22.2 M&M Theorem in Brief 22.3 M&M Theorem in Perfectly Efficient Markets 22.4 M&M Theorem in the Real World Part V: Indian Financial System 23. Financial Institutions 23.1 Classification of Financial Institutions in India 23.2 Financial Institutions in India at a Glance 23.3 Regulation and Supervision of Financial Institutions in India 24. Financial Markets 24.1 Importance of Financial Markets 24.2 Regulation and Supervision of Financial Markets in India 24.3 Money Market 24.4 Government Securities Market 24.5 Capital Market 24.6 Foreign Exchange Market 25. Financial Instruments 25.1 Direct Financial Instruments 25.2 Derivative Financial Instruments 26. Financial Inclusion 26.1 Origins of the Current Approach to Financial Inclusion 26.2 Financial Exclusion and Financial Inclusion Defined 26.3 Advantages of Financial Inclusion 26.4 Measures Taken by Reserve Bank of India (RBI) for Financial Inclusion 26.5 Financial Inclusion Measures by NABARD 26.6 Committee on Financial Inclusion 26.7 Committee on Comprehensive Financial Services for Small Businesses and Low-income Households (CCFS), 2014 26.8 Pradhan Mantri Jan-Dhan Yojana (PMJDY), 2014 27. Financial Regulators 27.1 Ministry of Finance, Government of India 27.2 Reserve Bank of India (RBI) 27.3 Ministry of Corporate Affairs 27.4 Securities and Exchange Board of India (SEBI) 27.5 Insurance Regulatory and Development Authority (IRDA) 27.6 Pension Fund Regulatory and Development Authority (PFRDA) 27.7 Monitoring Framework for Financial Conglomerates (FCs) 28. Legislative and Institutional Measures to Strengthen Financial Sector 28.1 Prevention of Money Laundering Act (PMLA), 2002 28.2 Credit Information Companies (Regulation) Act, 2005 28.3 Government Securities Act, 2006 28.4 Payment and Settlement Systems Act, 2007 28.5 Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 28.6 Benami Transactions (Prohibition) Amendment Act, 2016 28.7 High Level Committee on Financial Sector Reforms, 2008 28.8 Committee on Financial Sector Assessment (CFSA), 2009 28.9 Financial Sector Legislative Reforms Commission (FSLRC), 2013 28.10 Indian Financial Code (IFC) 28.11 Financial Stability and Development Council (FSDC) 28.12 Financial Action Task Force (FATF) 28.13 Financial Stability Board (FSB) Suggested Readings Index ABOUT THE AUTHOR Dr. G. Yoganandham is currently Associate Professor and Head, Department of Economics, Thiruvalluvar University, Vellore, Tamil Nadu. He received his M.A. (Economics) degree from Loyola College, Chennai and M.Phil. and Ph.D. degrees from Department of Economics, University of Madras, Chennai. He was awarded Doctoral Research Fellowship by the Ministry of Social Justice and Empowerment, Government of India, New Delhi. The Indian Council of Social Science Research (ICSSR), New Delhi awarded him General Research Fellowship to pursue his post-doctoral research studies. He has actively participated and presented papers at various regional, national, and international conferences, seminars, and workshops. In 2019, he won the Eminent Social Scientist Award, for his outstanding contribution in applied economic research, from Global Peace University, USA. He has published a number of books including Causes and Consequences of Demonetization in India: A Critical Assessment, Asian Management Economics and Commerce Association Publications, 2017. He has 24 years of teaching and research experience in the field of applied economics. Till date, 8 Ph.D. degrees and 32 M.Phil. degrees have been awarded under his guidance and supervision.