State Preference Theory

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 The State Preference Theory
• The State Preference Theory is platform to begin our
more in-depth discussion of securities and security prices

• Here we will shift from -

“individual’s choice problem of mutually exclusive
investments” to “Portfolio decision making”

• ASSUMPTION
A perfect capital market with no cost of portfolio
construction
Basics of the State Preference Theory
• Securities inherently have a time dimension as the passage of time
involves uncertainty about the future and hence about the future value
of a security investment.

• In the State Preference Theory, uncertainty takes the form of not

knowing what the state of nature will be at some future date.

• Once the uncertain state of the world is revealed, the payoff on the
security is determined exactly.

• From the standpoint of both the issuing firm and the individual
investor, the uncertain future value of a security can, therefore, be
represented as a vector of probable payoffs at some future date.

• The investor’s portfolio can then be characterized as a matrix of

possible payoffs on his securities.
An Example of the State Preference Model

❖ In the simplest case, there are two possible outcomes with

probabilities πI and π2 and therefore two mutually exclusive states
of nature with probabilities πI and π2. Take as an example an
investment in a lottery ticket with outcomes ($10,000, $0). With
probability πI , state 1 is realized and the lottery ticket pays off
$10,000; with probability π2 = 1 - πI, state 2 is realized and the
lottery ticket pays off nothing.
❖ The probability of a state of nature occurring is thus equal to the
probability of the associated end-of-period security payoff.
 Uncertainty and Alternative Future States
❖ The states of nature are assumed to capture the
fundamental causes of economic uncertainty in the
economy;
• e.g., State 1: Peace; State 2: War
• e.g., State 1: Prosperity; State 2: Normalcy; State 3:
Recession; State 4: Depression
❖ Once the state of nature is known, the end-of-period payoff
at each risky security is also known.
❖ In principle, there can be an infinite number of states of
nature and thus an infinite number of end-of-period payoffs
for a risky asset. This set of states must meet the critical
properties of being mutually exclusive and exhaustive.
• One and only one state of nature will be realized at the
end of the period, and the sum of the probabilities of
the individual states of nature equals one.
❖ Individuals can associate an outcome from each security’s
probability distribution of its end of period payoff with
each state of nature that could occur.
❖ Market securities are defined with respect to the
characteristics of their payoffs under each alternative future
state. A market security thus consists of a set of payoff
characteristics distributed over states of nature
 Definition of Pure Securities

• Analytically, the generalization of the standard, timeless,

microeconomic analysis under certainty to a multiperiod economy
under uncertainty with securities markets is facilitated by the
concept of the pure security.
• A pure or primitive security is defined as a security that pays Re.1 at
the end of the period if a given state occurs and nothing if any other
state occurs
• The concept of the pure security allows the logical decomposition of
market securities into portfolio of pure securities.
• Thus, every market security may be considered a combination of
various pure securities.
 Complete Capital Market
• When the number of unique linearly independent securities is equal to the
total number of alternative future states of nature, the market is said to be
complete.
• e.g., suppose there are three states of nature, and also suppose that a risk-
free asset with payoff (1,1,1), an unemployment insurance contract with
payoff (1,0,0), and risky debt with payoff (0,1,1) all exist. But we still do
not have a complete market in this case, because (1,1,1,) is the sum of
(1,0,0) and (0,1,1); that is, these three securities are not linearly
independent.
• e.g., suppose there are three states of nature, and also suppose that a risk-
free asset with payoff (1,1,1), an unemployment insurance contract with
payoff (1,0,0), and risky debt with payoff (0,1,1) all exist. In addition, you
also have a stock with payoff (0,1,3). There are three states of nature and 3
linearly independent securities → a complete market
 Complete Capital Market
• If the market is incomplete, then not every possible security payoff can be
constructed from a portfolio of the existing securities.
• For instance, using our previous example, the security payoff (0,1,0)
can not be obtained from (1,1,1), (1,0,0) and (0,1,1).
• But it can be obtained from (0,1,3) (1,0,0) and (0,1,1).
• Similarly, we can construct (1,0,0) and (0,0,1) from certain combination of
(0,1,3) (1,0,0) and (0,1,1).
• Once we have (1,0,0) (0,1,0) and (0,0,1); that is, we have three pure
securities, it is easy to replicate any other security from a linear
combination of the pure securities.
• For instance, a security with a payoff (a,b,c) can be replicated by
buying (or short selling if a, b, or c is negative) a of (1,0,0), b of (0,1,0),
and c of (0,0,1)
Derivation of Pure Security Prices

• Given that we know the state-contingent payoff vectors of both the

market securities and the pure securities, we now can develop the
relationship between the prices of the market securities and pure
securities in a complete market.
• Let’s see an example
Derivation of Pure Security Prices

• Payoff table for securities j and k

Security State 1 State 2
j 10 20 𝐩𝐣 = 8

k 30 10 𝐩𝐤 = 𝟗

• Security j pays 10 if state 1 occurs and pays 20 if state 2 occurs

• Security k pays 30 if state 1 occurs and pays 10 if state 2 occurs
• Security j costs 8 and security k costs 9.
Derivation of Pure Security Prices

𝑝𝑠 = price of pure securities

𝑝𝑗 = price of market securities
𝜋𝑠 = state probability-individual' s beliefs about the relative likelihoods of states occurring
𝑄𝑠 = number of pure securities Hence:
𝑝1𝑄𝑗1 + 𝑝2𝑄𝑗2 = 𝑝𝑗
𝑝1𝑄𝑘1 + 𝑝2𝑄𝑘2 = 𝑝𝑘
Or
𝑝110 + 𝑝220 = 8
𝑝130 + 𝑝210 = 9
Solve for 𝑝1 and 𝑝2:
𝑝1 = 0.2
𝑝2 = 0.3
Derivation of Pure Security Prices

𝑝1 = 0.2
𝑝2 = 0.3
The results indicate that for pure security 1, a Re. 0.20 payment is required for a
promise of a payoff of Re. 1 if state 1 occurs and nothing if any other states
occur.
The results indicate that for pure security 2, a Re. 0.30 payment is required for a
promise of a payoff of Re. 1 if state 1 occurs and nothing if any other states
occur.
Security j: a portfolio of 10 pure securities 1 and 20 pure securities 2 Security k:
a portfolio of 30 pure securities 1 and 10 pure securities 2
 No-Arbitrage Profit Condition
• Capital market equilibrium requires that market prices be
set so that supply equals demand for each individual
security.
• As such, in the context of the state preference
framework, one condition necessary for market
equilibrium requires that any two securities or portfolios
with the same state-contingent payoff vectors must be
priced identically.
• This condition is known as the single-price law of
markets
• If this condition is not met, everyone would want to buy
the security or portfolio with the lower price and to sell
the security or portfolio with the higher price.
 No-Arbitrage Profit Condition
• Now, if short-selling is allowed in the capital market, we can obtain a second
related necessary condition for market equilibrium—the absence of any
riskless arbitrage profit opportunity.
• How to short-sell a security?
❖ Borrow the security from another market participant who owns it, and
immediately sell the security in the capital market at the current price.
❖ At a later date, the investor purchases the security from the capital market at
the then prevailing market price.
❖ The investor returns the borrowed security to the lender
❖ If the security price fall over the period of the short sale, the investor makes
a profit equal to the difference of the prices minus the cost of borrowing the
security from another market participant → Such an arbitrate opportunity is
inconsistent with market equilibrium
• Since in a complete market any market security’s payoff vector can be exactly
replicated by a portfolio of pure securities, when short-selling is allowed the no
arbitrage profit condition requires that the price of the market security is equal to
the price of any linear combination of pure securities that replicates the market
security’s payoff vector.
 Optimal Portfolio Decisions
• Now we have discussed the basic structure of State Preference Theory, we
move to the problem of optimal portfolio choice in a complete capital
market.
• As discussed earlier, any portfolio payoff pattern can be constructed from
the existing market securities or from a full set of pure securities in a
complete capital market.
• Since pure securities are much simpler to analyse, we will present the
optimal portfolio problem in the framework of pure securities.
Optimal Portfolio Decisions
Optimal Portfolio Decisions
 Optimal Portfolio Decisions

LM = Measure of how much our utility would increase if

our initial wealth were increased by 1
 Quick Activity

Consider an investor with a logarithmic utility

function of wealth and initial wealth of $10,000.
Assume a two-state world where the pure security
prices are .4 and .6 and the state probabilities are
1/3 and 2/3, respectively. How will this investor
divide his or his wealth between the current and
future consumption ?
Quick Activity
Quick Activity
 The Efficient Set: Two Risky Assets and No Risk-Free Asset

• For any risk averse investor, to maximise his/her

expected utility, what are the portfolio optimality
conditions?
• Important portfolio optimality conditions for any risk
averse expected utility maximizer
tU ' (Qt ) pt
• = for any state t
u ' (C ) $1
tU ' (Qt ) pt
• = for any two states s and t
sU ' (Qs ) ps

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The Efficient Set: Two Risky Assets and No Risk-Free Asset

• Optimal consumption/investment decision

This is equivalent to choosing consumption and investment
weights so that the slopes of the indifference curves
representing consumption and investment contingent on
state t is the same as the slopes of the respective market
lines.

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The Efficient Set: Two Risky Assets and No Risk-Free Asset

• Optimal portfolio decision

This is equivalent to choosing investment weights among
two assets so that the slopes of the indifference curves
representing investment of two asset contingent on state
t and s is the same as the slopes of the respective market
lines.

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