Allocation of Risk

Virtually all real assets involve some risk. When GM builds its auto plants, for example, its management cannot know for sure what cash flows those plants will generate. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other less-risk-tolerant individuals can, to

6 PART I Introduction a greater extent, stay on the sidelines. For example, if GM raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic, or risk-tolerant, investors buy shares of stock in GM. The more conservative individuals can buy GM bonds, which promise to provide a fixed payment. The stockholders bear most of the business risk along with potentially higher rewards. Thus capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors can self-select into security types with risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economy's stock of real assets.

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