fin5b - Portfolio Tools 1 Econ 333 Spring 08 1 Portfolio...

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Econ 333 Spring 08 1 Portfolio Tools 1
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Econ 333 Spring 08 2 Portfolio Tools 1 Before 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) 1,600 1,050 -1000 Investment 3 1,600 500 -1000 Investment 2 1,200 1,050 -1000 Investment 1 Asset 2 Asset 1 State probab. π 1 = π 2 = 1/2 Value at t =1 Cost at t=0
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