1. Financial Market Theory
Thursday, September 7, 2017
Professor Edwin T Burton

2. 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

3. Diversification in a “Finite State” World
September 7, 2017

4. Finite States Tomorrow has three possibilities: Good State
Neutral State
Down State
September 7, 2017

5. 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

6. 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

7. 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

8. 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

9. 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