Monday, January 11, 2010

Equity as state contingent securities

Chris Dillow in the Investor Chronicle
So, there's a lot wrong with the standard view. Luckily, though, there's an alternative. Don't think of shares as the discounted present value of future cashflows at all. Think of them instead as state-contingent securities that pay off different amounts in different states of the world.
So volatility can be the result of small changes in the probability attached to extreme events rather than large changes in the risk premium. More here.

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