Financial Market Theory Thursday, September 7, 2017 Professor Edwin T Burton
Readings, So Far (Available on Collab) You should have already read Malkiel, “A Random Walk Down Wall Street” During the last two weeks, you should have read Chapters One, Two, Three and Four This week, you should read Chapters Five and Six September 7, 2017
Diversification in a “Finite State” World September 7, 2017
Finite States Tomorrow has three possibilities: Good State Neutral State Down State September 7, 2017
The Concept of “State Prices” The price today to receive $ 1 in a specific state tomorrow PS1 pays $ 1 if state one occurs and nothing in states 2 and 3 PS2 pays $ 1 if state two occurs and nothing in states 1 and 3 PS3 pays $ 1 if state three occurs and nothing in states 1 and 2 September 7, 2017
What is the risk free security in the “finite state” world Risk Free Security pays $ 1 regardless of whether state 1, 2, or 3 occurs September 7, 2017
What is diversification in the “finite state” world What is meant by the “bad” state? This is the state where most securities do very poorly If so, diversification must mean owning more securities in this state We will find out later in the course that the price of a the “bad” state security, PS3, is higher than the price of the “good” state security, PS1 In fact, PS3 > PS2 >PS1 September 7, 2017
What is the “risk free rate” in the “finite state” world You could buy each of the “state securities,” one for each state Pay PS1 + PS2 + PS3 today to receive exactly one dollar tomorrow Total Return is $ 1 minus ( PS1 + PS2 + PS3) Percentage Return is {1 - ( PS1 + PS2 + PS3)} ( PS1 + PS2 + PS3) The above percentage return is the risk free rate September 7, 2017
Risk Free Securities in the Real World Sovereign Debt is the “Default Free Security” in the “Home” Country In the US, this means US Treasury Securities In Japan, this would mean Japanese Government Bonds, etc. In any country, it will mean government debt (Greece?) Risk Free Asset will be a “default free security” with the shortest maturity In the US, this will be a treasury security with one day remaining in maturity Could be approximated by the “repo rate” (repurchase agreement rate) September 7, 2017