• Consider a simple economy with two equally likely possible states and an investor owns a portfolio worth $400,000 that will pay $0 in state 1 or $1,000,000 in state 2
• What is the expected return and the volatility of return?
• Consider adding a security that costs $500,000 and pays $1,000,000 in state 1 and $0 in state 2
• (The expected return is 0% and the volatility is 100%)
• The risk-free rate is 5%
• Should the investor purchase the security?