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Econ 333 Spring 081Portfolio Tools 1
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Econ 333 Spring 082Portfolio Tools 1Before one turns to modeling asset pricing it is essential to understand the determinants of the demand for securities of various risk classes (Individuals demand securities (in exchange of current purchasing power) in their attempt to redistribute income across time and states of nature).When talking of the “risk” of an investment, people generally have in mind uncertainty in the future cash-flow stream: much lower payments may be received in some states than in others. Thus cash flow in any future period is a random variable.Consider the following investments:(Table 1)1,6001,050-1000Investment 31,600500-1000Investment 21,2001,050-1000Investment 1Asset 2Asset 1State probab. π1 = π2 = 1/2Value at t =1Cost at t=0