Numerous economists have explained the role of finance in the market with the help of different finance theories. The concept of finance theory involves studying the various ways by which businesses and individuals raise money, as well as how money is allocated to projects while considering the risk factors associated with them.
The concept of finance also includes the study of money and other assets, managing and profiling project risks, control and management of assets, and the science of managing money. In simple terms, 'financing' also means provision and allocation of funds for a particular business module or project.
There are a number of finance theories that offer separate approaches to the finance hypotheses. Some of the major popular finance theories of the world are: Arbitrage Pricing Theory, Rational Choice Theory, Prospect Theory, Cumulative Prospect Theory, Monte Carlo Option Model, Binomial Options Pricing Model, Gordon Model, International Fisher Effect, Black Model, and Legal Origins Theory.
The Arbitrage Pricing Theory, for example, addresses the general theory of asset pricing. Proper asset pricing is necessary for the proper pricing of shares. The Arbitrage Pricing Theory states that the return that is expected from a financial asset can be presented as a linear function of various theoretical market indices and macro-economic factors. Here it is assumed that the factors considered are sensitive to changes, and that is represented by a factor-specific beta coefficient.
The Prospect Theory, on the other hand, takes into consideration the alternatives that come with uncertain outcomes. The model is descriptive by nature and attempts to represent real-life choices but not optimal decisions.
Modern Portfolio Theory (MPT) proposes how rational investors should use diversification in order to optimize their portfolios. It also discusses how a risky asset should be priced.
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