Risk Analysis in Theory and Practice
Presenting a mix of conceptual analyses and applied problems, this book provides useful insights into the economic rationality of decision-making under uncertainty.
TABLE OF CONTENTS Risk Analysis in Theory and Practice
Chapter 9: Portfolio Selection
This chapter focuses on optimal investment decision under uncertainty. A central issue is the role of risk and risk aversion in investment behavior. We start with the case of an investor choosing between two assets: a risky asset and a riskless asset. In this simple case, we obtain useful analytical insights on the effects of risk on portfolio selection. We then examine the general case of multiple risky assets. In a mean-variance context, we investigate the optimal portfolio selection among risky assets and its implications for empirical analysis. When taken to the market level, the optimal behavior of investors provides a framework to investigate the market price determination in the stock market. This is the standard capital asset pricing model (CAPM). Extensions to the capital asset pricing model are also discussed.
THE CASE OF TWO ASSETS
Consider an agent (it could be a firm or a household) choosing an investment strategy. We start with the simple case where there are only two investment options: a riskless asset and a risky asset. The investor has a one-period planning horizon. His/her investment decisions are made at the beginning of the period, yielding a monetary return at the end of the period. For each dollar invested, the riskless asset yields a sure return at the end of the period. The riskless asset can be taken to a government bond, which is considered to exhibit no risk of default. In contrast, the risky asset yields an uncertain return at the end of the period.
Copyright Elsevier Inc. 2004 under license agreement with Books24x7
