Massimo Acquaviva, 2R Capital Investment Management Limited co-CEO and co-founder, is an experienced businessman who takes a keen interest in talent acquisition, retention and investment training. This article will explore the topic of financial theory, exploring its multi-layered applications as a career field centring around managing and facilitating the transfer of money, currency and assets, as well as providing an overview of common financial theories.
Important theories that underpin modern finance revolve around behavioural finance, financial mathematics and quantitative analysis, experimental finance, managerial finance, quantum finance and financial economics. Although ‘finance’ and ‘economics’ are words that are sometimes used interchangeably, in reality, there is a key distinction between them. While in economics, real value centres around goods and services, in finance the focus is on shares, prices and interest rates. Financial economics is a field that examines the relationship between these two distinct aspects, its models largely focusing on decision-making, risk management and pricing in financial markets. Financial economics has come under a great deal of fire due to the long-held notion that price changes should be dictated by a combination of distribution and rational expectations versus market efficiency.
Important financial theories include:
- Risk and Return: A theory that explores the relationship between financial risk and returns. Generally speaking, the higher the level of risk, the greater the potential returns, since investors expect to be compensated in accordance with the level of risk they incur.
- Time Value of Money: A principle that states a specific amount of money is worth more today than the same amount in the future. This concept forms the basis for discounted cash flow analysis and various valuation models.
- Agency Theory: A concept that examines the relationships and potential conflicts of interest between a firm’s various stakeholders, including management, shareholders and creditors.
- Portfolio Theory: A concept theorised by Harry Markowitz that emphasizes the need to diversify investment portfolios in order to reduce risk. According to Markowitz, by combining different asset classes within a single portfolio, investors can achieve a better risk-return trade-off.
- Option Pricing Theory: A principle that centres around options that give the holder the right to buy and sell an asset at a predetermined price. Option Pricing Theory analyses options using pricing models like the Black-Scholes model to help investors and companies assess the value of options to better manage risk.
- Capital Structure Theory: Addressing the mix of equity and debt financing that a business uses to fund its operation. This theory looks at how a company’s capital structure impacts the cost of its capital and consequently its value.
- Efficient Market Hypothesis: A concept which revolves around the principle that financial markets are informationally efficient, i.e. that asset prices fully reflect all available information. In an efficient market, it is challenging to consistently achieve above-average returns through stock picking or market timing.
- Although not strictly a theory in the traditional sense, behavioural finance incorporates psychological factors into financial decision-making, exploring how investors’ emotions, social influences and cognitive biases affect their behaviour, in turn, affecting financial markets.
Teaching with Historical Perspectives (THP) helps students to move beyond the idea that finance is a set of specific distributionally neutral techniques. It supports curriculum diversification by reflecting on the evolution of financial vehicles and techniques, as well as exploring the historical evolution of theories that underpin understanding of those techniques. THP can be used in an array of different ways, and can be particularly helpful in contextualizing the genesis of a theory or model, or to introduce pluralism. THP also provides a helpful framework for explaining the evolution of theories and models while simultaneously locating various models within the same or competing schools of thought.
