ABSTRACT
The introduction of assets into exchange rate models raises the issue of wealth - its level and its composition. To keep the analysis tractable we shall assume in all that follows that wealth can be held in, at most, only four forms: domestic and foreign money and domestic and foreign short-term bills. This does not do justice to the menu of financial assets actually available, but it suffices for our purposes. (We use short-term bills as our non-monetary asset in order to avoid the difficulty that the capital values of long-run instruments vary with the interest rate.)
say much about the latter, save to note that risk can normally be reduced by diversification. In a diversified portfolio the assets that are doing badly are at least partly compensated for by those that are doing well; in a concentrated one you may do very well, but you may do very badly if you choose wrongly. Hence, if people are risk averse, they will hold assets with returns lower than the maximum available, just in order to be more secure. That is, they will trade off returns against security. If the risk properties of an asset change, people may well rearrange their portfolio because the terms of this trade-off will have altered.
