Consider a world of two countries highland h and lowland l

Reference no: EM13378857

Consider a world of two countries; Highland (H) and Lowland (L). Each country has an average output of 9 and desires to smooth consumption. All income takes the form of capital income and is fully consumed each period. There are two states of the world: Pestilence (P) and Flood (F). Each happens with 50% probability. Pestilence affects Highland and lowers the output there to 8, leaving Lowland unaffected with an output of 10. Flood affects Lowland and lowers the output there to 8, leaving Highland unaffected with an output of 10. Devise a table with two rows corresponding to each state (rows marked P and F). In three columns, show income to three portfolios: the portfolio of 100% claims to H output, the portfolio of 100% claims to L output, and the portfolio of 50% claims to H output + 50% claims to L output. Does diversification eliminate consumption risk?

Reference no: EM13378857

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