A Simple Framework A Simple Framework

We will explore these concepts within a simple
framework:
• Two periods, “now” and “the future”
• A finite number S of states may occur in the
future. The states are numbered j=1…S.
• A finite number of assets are available. The
assets are numbered i=1…N.
• Assets are defined by their payoffs. Asset i pays
off Xij in state j.
• The price of asset i is written pi.
• The N securities are jointly defined by an N-by-S
matrix X whose i,j element is Xij. (each security
is a row; each state is a column)
• The prices of the N securities can be stacked
into a N-by-1 vector p.

Portfolio Construction Example

• We can form a portfolio by buying wi shares of States:
asset i, i=1…N. If we stack the number of Farm: [3 2 1] (j= rain, small drought, large drought)
shares into a N-by-1 vector w, then
– the payoff on the portfolio is W=w’X Assets:
((1xN)x(NxS)=1xS, payoff in each of S state) • [3 2 1] (i=1 whole farm, p1=2)
and
• [2 2 1] (i=2, first 2 dollars produced, p2=1.75)
– the price of the portfolio is w’p. (1xN)x(Nx1)=1
• [1 1 1] (i=3 first dollar produced, p3=1)
• The portfolio is just a new asset that we have
constructed using the old ones.

Example continued portfolios

States are columns, assets are rows w (3x1) = (for example)
X (3x3) = p (3x1)=

1
3 2 1 2 -1
2 2 1 1.75 0
1 1 1 1