186 PART II Portfolio Theory

CONCEPT

C H E C K ☞

QUESTION 1

Rather than thinking of our risky holdings as E and B stock separately, we may view our holdings as if they were in a single fund that holds equities and bonds in fixed proportions.

In this sense we may treat the risky fund as a single risky asset, that asset being a particular bundle of securities. As we shift in and out of safe assets, we simply alter our holdings of that bundle of securities commensurately.

Given this simplification, we can now turn to the desirability of reducing risk by chang- ing the risky/risk-free asset mix, that is, reducing risk by decreasing the proportion y. As long as we do not alter the weights of each security within the risky portfolio, the proba- bility distribution of the rate of return on the risky portfolio remains unchanged by the as- set reallocation. What will change is the probability distribution of the rate of return on the complete portfolio that consists of the risky asset and the risk-free asset.

What will be the dollar value of your position in equities (E), and its proportion in your overall portfolio, if you decide to hold 50% of your investment budget in Ready Asset?

7.2 THE RISK-FREE ASSET

By virtue of its power to tax and control the money supply, only the government can issue default-free bonds. Even the default-free guarantee by itself is not sufficient to make the bonds risk-free in real terms. The only risk-free asset in real terms would be a perfectly price-indexed bond. Moreover, a default-free perfectly indexed bond offers a guaranteed real rate to an investor only if the maturity of the bond is identical to the investors desired holding period. Even