Financial institutions in an economy pool the savings of investors and invest them in enterprises or assets that generate uncertain returns. In this section,we consider the pivotal role of financial institutions in an economy. In a basic sense, the existence of financial institutions is justifiable only if they can improve the risk-return trade off for participants in the financial markets.
The CAPM theory described above assumes that an asset is infinitely divisible; hence, an investor having a small endowment can still construct a portfolio that mirrors the market portfolio. In reality, such a possibility does not exist. This divergence underscores the critical relevance of the notion of actuarial risk and the pivotal role played by financial institutions in making it achievable by investors. Suppose an investor has $1,000 to invest and she seeks to invest it in a company whose shares are selling at $1,000 apiece and this company faces a 10 percent chance of failure. If a failure occurs, the investor will lose all her money.Thus the likelihood of 10 percent is meaningless for our investor.
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