Portfolio analysis is concerned with the development of theoretical models designed to analyse the factors affecting the financial assets held by economic agents, together with the empirical testing of these models. The agents may be individuals and firms, in which case we are concerned with the way in which private sector wealth is allocated between different assets, or alternatively financial institutions where the deposits of customers are allocated among competing assets so as to satisfy the balance sheet identity. Such an approach to asset choice decisions has its roots in early studies of the demand for money. In his formulation of the speculative demand for money, Keynes analysed the way in which individuals allocate their given wealth between interest-bearing bonds and money in the form of cash balances which earns no pecuniary return. The choice is based upon the expected holding-period return on bonds, which not only depends upon the interest income, but also upon expectations about movements in the market rate of interest and hence the price of bonds; these expectations will, in turn, be based on what is perceived to be the ‘normal’ rate of interest. If market rates are low, below the ‘normal’ rate, and therefore expected to rise over the holding period, a capital loss is to be expected on bond holding; individuals will sell bonds and hold their entire portfolio in cash, as long as the interest income from bond holding is not enough to offset this expected capital loss. On the other hand, if market rates are high, above the ‘normal’ rate, and expected to fall over the holding period, individuals will expect capital gains from bond holding; they will accordingly transfer their wealth from cash to bonds.
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