Conventional finance, also known as traditional finance or neoclassical finance, is a school of thought in economics that explains how markets function, investments should be priced, and financial decisions should be made assuming that investors are rational, markets are efficient, and prices reflect all available information. It serves as the bedrock for many theories and models used in the financial world. At the heart of conventional finance lies the **Efficient Market Hypothesis (EMH)**. The EMH postulates that market prices fully reflect all available information. This implies that it’s impossible to consistently outperform the market on a risk-adjusted basis because any new information is immediately incorporated into asset prices. There are three forms of the EMH: * **Weak Form:** Prices reflect all past market data, such as price and volume. Technical analysis, which relies on charting and past price movements, is deemed ineffective under this form. * **Semi-Strong Form:** Prices reflect all publicly available information, including financial statements, news articles, and economic data. Fundamental analysis, which involves evaluating a company’s financial health and future prospects, is rendered useless for generating excess returns. * **Strong Form:** Prices reflect all information, both public and private (insider) information. Even those with privileged information cannot consistently outperform the market. Under the framework of conventional finance, investors are presumed to be **rational actors**. This means they make decisions based on logic and reason, aiming to maximize their expected utility. They carefully weigh the costs and benefits of each investment opportunity, taking into account factors such as risk, return, and time value of money. They are risk-averse, meaning they prefer lower risk for a given level of expected return. Key theories within conventional finance include: * **Modern Portfolio Theory (MPT):** Developed by Harry Markowitz, MPT emphasizes diversification to optimize portfolio returns for a given level of risk. By combining assets with different correlations, investors can reduce overall portfolio volatility without sacrificing returns. MPT introduces the concept of the “efficient frontier,” which represents the set of portfolios offering the highest possible expected return for each level of risk. * **Capital Asset Pricing Model (CAPM):** The CAPM builds upon MPT and provides a framework for determining the expected return of an asset based on its systematic risk, measured by beta. Beta represents the asset’s volatility relative to the overall market. The CAPM equation links the expected return of an asset to the risk-free rate, the asset’s beta, and the market risk premium. * **Option Pricing Theory:** Models like the Black-Scholes model provide a mathematical framework for pricing options contracts. These models rely on assumptions about the behavior of underlying asset prices and market efficiency. Conventional finance provides a powerful framework for understanding financial markets and making investment decisions. It offers tools and models for valuing assets, managing risk, and constructing optimal portfolios. However, it’s important to recognize its limitations. Behavioral finance challenges the assumption of investor rationality, highlighting the influence of cognitive biases and emotions on investment decisions. Market anomalies, such as the January effect or momentum effect, also contradict the EMH, suggesting that markets may not always be perfectly efficient. Despite these criticisms, conventional finance remains a cornerstone of modern financial theory and practice.
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