Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

Indice
1. Introduction with a example in Finance
1.1. Simple example: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1
1

2. General Description of the State-Preference Model

2.1. Asset valuation . . . . . . . . . . . . . . . . . . . . . .
2.2. Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . .
2.3. State-prices . . . . . . . . . . . . . . . . . . . . . . . .
2.4. First Fundamental Theorem . . . . . . . . . . . . . . .

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3. First Fundamental Theorem State Preference Valuation

3.1. The implications of the First Fundamental Theorem (FT1) . . . . . . . . . . . . . . . .

5
5

4. State prices, risk adjustments, discount rates

4.1. Backing out the riskless rate of interest from state prices . . . . . . . . . . . . . . . . . .
4.2. Risk-neutral valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3. How risk affects valuations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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5. Consequences of Competitive Financial Markets

5.1. Irrelevance of capital structure changes that dont effect total cash flows . . . . . . . . .

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6. Investment Policy in Competitive Financial Markets: Always Maximize NPV

1.
1.1.

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11

Introduction with a example in Finance

Simple example:

Imagine a very simple world which we will call SIMPLE WORLD. This world last one period. At
the Start of period, time 0, the investors in simple world decide on the portfolio of securities they are
going to hold. At time 1, the cash flows from these securities are realized. These cash flows depend only
on the state of the economy. And, because SIMPLE WORLD is, well, simple, the economy can be in
one of two possible states: BOOM or BUST. Three stocks trade on the security market, the stocks of 1
Corp., 2 Corp., and 3 Corp. A share of 2 Corp. stock is worth $2.00 if a BOOM occurs and $1.00 if BUST
occurs. A share of 3 Corp. is worth $0.00 if a BOOM occurs and $1.00 if BUST occurs. The price of a
share of 2 Corp. stock at time zero is equal to 1.38; the price of 3 Corp. stock at time zero is equal to 0,48.
Consider the problem of a corporate manager making policy decisions for one of the companies in
SIMPLE WORLD-1 Corp. is owned by 100 different shareholders. Before trading at time 0, the investors
in 1 Corp. have all of their wealth tied up in 1 Corp. Suppose the manager has to choose between two
mutually exclusive operating polices. If policy A is followed, the firms cash flow will be 100y1A , where
y1A is the payoff to a single share of 1 Corp. stock if policy A is undertaken. If policy B is undertaken,
the firms payoff will be 100y1A , where y1B is the payoff to a single share of 1 Corp. stock if policy B is
undertaken. These cash flows depend on the state of economy. The payoffs on a share of 1 Corp.s stock
if policy A is followed are given below:

y1A (BOOM ) = 5
,
y1A (BU ST ) = 1

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

The payoffs under policy B are:

y1B (BOOM ) = y1B (BU ST ) = 2

The investors of 1 Corp. believe that BOOM and BUST are equally likely. That is (BOOM ) =
(BU ST ) = 1/2. If the investors in 1 Corp. do not trade on financial markets, their payoff at the end
of period will be y1A if a policy A is adopted and y1B if policy B is adopted. Moreover, the investors are
very risk averse. Thus, they all prefer y1B to y1A . The payoffs on all the stocks trading in the economy
are given below.

State
BOOM
BUST
Price

Cuadro 1: The payoffs

1 Corp
Probability() Policy A Policy B
0.50
5.00
2.00
0.50
1.00
2.00
??
??

2 Corp

3 Corp

2.00
1.00
1.38

0.00
1.00
0.48

Question: Suppose that the investors in 1 Corp. are able to trade in financial markets at time 0.
Also suppose that financial markets do not permit arbitrage. That there do not exist trading strategies
that permit investors to translate a zero or negative investment at time 0 into a portfolio that never
losses money (and sometimes makes money) at time 1.
a. What will the price of 1 Corps stock equal if it adopts policy A?
b. What will the price of 1 Corps stock equal if it adopts policy B?
c. If investors can trade, what policy will they prefer the firm to adopt: A or B? Why?
d. Suppose investors cannot trade on financial markets at time 0. What policy will they prefer:
A or B? Why?
ANSWER: Suppose you buy 2.5 shares of 2 Corp. and short sell 1.5 shares of 3 Corp. Your
payoff in BOOM state will equal (2,5)(2,00) (1,5)(0,00) = $5,00. Your payoff in Bust state will equal
(2,5)(1,00) (1,5)(1,00) = $1,00 this portfolio exactly replicates the cash flow from a share of 1 Corp.s
stock if it adopts policy A. Thus the price of a share if it adopts policy A must be exactly the same as
the price of this portfolio. the portfolio is worth (2,5)(1,38) (1,5)(0,48) = $2,73. Thus, in an efficient
financial market, 1 Corp.s stock price will be $2,73 if it adopts policy A.
Next, suppose you form a portfolio consisting of 1 share of 2 Corp. and 1 share of 3 Corp. Your
payoff in both the BOOM and the BUST states will equal 2.00. This is exactly to a single share form
Project B. Thus the price of a share of 1 Corp., if it adopts policy B, must exactly equal the price of
this portfolio. The portfolio is worth 1,38 + 0,48 = 1,86. Thus, n an efficient financial market, 1 Corp.s
stock price will be $1,86 if it adopts policy B.
If investors can trade, then no matter how risk averse an investor is, the investor will prefer policy
A to B even though A is much riskier than policy B. Why? If policy B is implemented, then an investor
2

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

owning 1 of the 100 outstanding shares can hold on to his initial holding in 1 Corp. and earn a sure
payoff of 1.186. on the other hand, if project A is undertaken, the investor can sell his share of 1 Corp.
for 2.73 and use the proceeds of the sale to buy shares in 2 Corp. and 3 Corp. A portfolio consisting of
1.46774 shares of 2 Corp. and 1.46774 share of 3 Corp. will cost $2.73, exactly the proceeds from selling
the share of 1 Corp. The payoff on this portfolio will equal 1,46774x2,00 = 2,93548 in both the BOOM
and the BUST states. Thus through a combination of trading and investing in project A our very risk
averse investor will be able to attain a riskless payoff of 2.93548 when the firm undertakes project A.
This is higher than the riskless of this project and his very high level of aversion.
It our risk averse investor cannot trade then, his is stuck with the risk profile produced by the
project the firm selects. The investor will thus prefer that the firm select B, the safer project.

2.

General Description of the State-Preference Model

Uncertainly about the future can be represented in terms of uncertainty about the realizations
of alignments of fundamental factors determining the state of the economy. Let each possible alignment
be called a state of nature, and let a state be represented by s S, where S represents a finite set,
containing all states of nature. In the SIMPLE EXAMPLE, S equaled BOOM, BUST. All agents in the
economy are able to associate a probability with each state of nature. Let the probability of occurrence
of state s be represented by (s), where
X

(s) = 1

.
and yi (s) is the payoff from security i in the state s. In the SIMPLE EXAMPLE, the probability
was defined by:

(BOOM ) = (BU ST ) = 1/2

.

2.1.

Asset valuation

To be able to value assets, we will first examine what is meant by arbitrage. Arbitrage is the term
used to denote the generation of positive returns when no investment is made and no risk undertaken.
Let wi represent the number of units of firm i purchased, and let vi represent the marker price of security
i. Suppose there are I securities trading in the economy. The set of securities is indexed by = 1, 2, I.
In the SIMPLE example = 1, 2, 3; a securities market is simply a collection of securities: yi : i = y.
For any given state of the world we have a vector of payoffs, one for each security. let y(s) represent this
vector. in other words

y1 (s)
y2 (s)

y(s) =

..

.
yn (s)
In the SIMPLE example, if 1 Corp. adopts policy A, then

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

5
1
y(BOOM ) = 2 ; y(BU ST ) = 1
1
1

2.2.

Arbitrage

An arbitrage portfolio is a portfolio that represents a money machine-make money without

putting money in or taking any risk. How can we capture this idea mathematically. First it is obvious that arbitrage requires that you do not have to make any initial investment. This implies that if
w = (w1 , wI ) is an arbitrage portfolio, it must satisfy the following condition.
X
(N oCost.)
wi vi 0
i

.
In addition an arbitrage portfolio does produces a loss in any state of the world,thus it must
satisfy the following condition,
X
(N oLoss)s,
wi yi (s) 0
i

However the nothing portfolio consisting investment of zero in all securities satisfies both of
these conditions and no one would call the nothing portfolio an arbitrage portfolio. So we require one
further condition, that there is some gain generated at some time by the portfolio. That is we require
that
(SomeGain)(F orsomestates)
X
wi yi (s) > 0
i

or
X

wi vi < 0

Any portfolio w satisfying (NoCost), (NoLoss), and (SomeGain) is called an arbitrage portfolio.

2.3.

State-prices

How do you value a bag of groceries. Even a Finance Professor can handle this question-count
each item in the bag, multiply the count by price of the item, and sum up over all the items. Here is
an easy way to value financial claims-find out how much the claim pays out in ever state, multiply that
payoff by the price of cash flows in that state and sum up.
For this scheme to work there must be a price p(s) associated with each possible state, s, such
that p(s) > 0 for all s S. If the prices of all claims trading in the economy are determined by p, then
we call p a state-price vector. In other words if, for every security i
X
vi =
p(s)yi (s)
S

,
then p is a state-price vector.

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

2.4.

Universidad de Chile

First Fundamental Theorem

The catch is that there might not be a single price vector that will simultaneously price all of the
many financial claims trading in the economy. Fortunately, it is possible o prove a very useful result-the
First Fundamental Theorem os State Preference Valuation-that shows that if arbitrage is not possible
a state price vector must exist.

3.

First Fundamental Theorem State Preference Valuation

Either,
(A) there exists an arbitrage portfolio, or (exclusive) (SP) there exits a state-price vector.

Since we can be fairly confident that there are no money-machines in the economy, the important
consequence of the First Fundamental Theorem is that in any reasonable financial market we can find
a state price vector.
In the SIMPLE example, the state price vector exists, it is given by p(BOOM ) = 0,45, p(BU ST ) =
0,48. How do we know that this vector is a state-price vector? In order for vector to be a state price
vector it has to satisfy the two conditions given above, that is, (1) it must be positive and (2) it must
price all claims. The vector (p(BOOM ) = 0,45, p(BU ST ) = 0,48) is clearly positive. To see that it
prices all the claims, you need to show that
v2 = p(BOOM )y2 (BOOM ) + p(BU ST )y2 (BU ST )
v2 = p(BOOM )y3 (BOOM ) + p(BU ST )y3 (BU ST )

If you do the arithmetic using the table of values presented above, youll see that these equations
are satisfied. Thus, a state price vector exists. This implies, by the Fundamental Theorem, that no
arbitrage opportunities exist.

3.1.

The implications of the First Fundamental Theorem (FT1)

Since arbitrage opportunities do not exist in competitive financial markets, the main point of the
FT1 is that it shows that, in any competitive financial market, there exist a state price vector which
determines the values of all financial assets, Why is this important? The key consequence of existence of
state-price vector is value additivity: the value of the sum of two cash flows equals the sum of the values
of each of the cash flows. More formally, suppose that a firm consists of two investment projects, 1 and
2. The cash flow to project 1 is given by X1 (s), the cash flow to project 2 is given by X2 (s). What is
the value of a firm consisting of cash flows from project 1 and project 2?, V (X1 + X2)? From FT1 we
know that
X
V (X1 + X2 ) =
p(s)(X1 (s) + X2 (s))
S

.
Now suppose that the firm is split up into two firms, one of which owned the rights to the cash
flows from project 1, and the other, the rights to the cash flows from project 2. Then, using the state
price vector operator we can see that the values of the two new firms, given by V (X1 ) and V (X2 ), must
equal
X
V (X1 ) =
p(s)(X1 (s))
S

.
5

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

V (X2 ) =

p(s)(X2 (s))

.
From this its obvious that
V (X1 + X2 ) = V (X1 ) + V (X2 )
This result is called value-additivity. It means that in a competitive financial market, there is
no gain from splitting up cash flows. Well see later that this has profound consequences for capital
structure decisions.
Summary: If capital markets are competitive, a single state price vector determines the price
of all securities. Moreover, value additivity holds. Value is neither created nor destroyed by dividing up
cash flows in different ways.

4.

State prices, risk adjustments, discount rates

How do state price vectors relate to traditional discount rates and risk adjustments?
The state price approach to valuation is conceptually very simple. To determine the value of any
cash flow, X, follow this routine: for each state, s, take the cash flow in that state, X(s), multiply this
cash flow times the price of cash flows in the state, p(s), then sum up your answer over all the states.
This is exactly the routine you would follow to value a bag of groceries: find the quantity of each item
in the bag, multiply times the price, and sum up.
Although the state-price approach is conceptually simple, it probably seems a bit foreign. The
purpose of this section is to relate the state-price valuation approach to the valuation technology you
have seen in other finances courses.

4.1.

Backing out the riskless rate of interest from state prices

Determining the risk-free rate of return from state prices is fairly straightforward. First, consider
the traditional approach. Let rf represent the risk-free rate of return. By definition, 1/(1 + rf ) is the
price of riskless bond paying $1 at time 1. Using the state price vector to value the riskless bond one
obtains
(RF )
X
X
(1)p(s) =
p(s)
S

Thus, we obtain the relationship

(RF )
X
1
=
p(s)
1 + rf
S

In the SIMPLE EXAMPLE,

X
p(s) = p(BOOM ) + p(BU ST ) = 0,45 + 0,48 = 0,93,
S

and thus we have that 1/(1 + rf ) = 0,93, that is, rf = 7,5268 %.

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

4.2.

Universidad de Chile

Risk-neutral valuation

An interesting property of state preference valuation is that all assets can be valued as if investor
were risk-neutral. To see this, note that (RF) implies that
X
(1 + rf )p(s) = 1
S

Further (1 + rf )p(s) > 0 s. Thus, the numbers (1 + rf )p(s) sum up to 1 and are always positive.
This implies that (1 + rf )p(s) represents some sort of probability distribution, and the value of any asset
can be determined as follows
vi =

yi (s)p(s) =

1 X
1 X
yi (1 + rf )p(s) =
yi Q(s)
1 + rf
1 + rf
S

where q(s) = (1 + rf )p(s), and Q(s) represents some sort of the occurrence of state s. It follows
that each asset is valued as if investors just discounted, at the risk-free rate of return, the expectations
od its cash flows, where the probabilities of states are represented by Q(s). We call these probabilities
the risk-neutral probabilities associates with the state. In the SIMPLE EXAMPLE:
Q(BOOM ) = (1 + rf )p(BOOM ) = 0,483871
Q(BU ST ) = (1 + rf )p(BU ST ) = 0,516129
The valuation equation
vi =

1 X
yi Q(s)
1 + rf
S

shows the value of any security is just its expected discounted cash flows under the pseudoprobabilities. The above equation is called the risk-neutral valuation relationship. It is used extensively
in the option pricing literature and is one of the foundations for the valuation models used by the
contingent-claims quant groups on Wall Street. State price vectors and risk adjusted discount rates.

4.3.

How risk affects valuations?

What is the relationship between the actual probabilities of the states (s) and the pseudo probabilities? To analyze this question, let q(s) = Q(s)/(s). In the simple example we have that

q(BOOM ) = Q(BOOM )/(BOOM ) = 0,483871/0,5000 = 0,967742

q(BU ST ) = Q(BU ST )/(BU ST ) = 0,51629/0,5000 = 1,03226

We then have the identity

Q(s) = q(s)(s)

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

.
The term q(s), is called the pricing density. It measures the degree to which prices diverge from
the prices which would obtain if agents were risk-neutral. (If agents were risk neutral than q(s) = 1
states. Thus, the pricing density is risk-adjustment factor. it follows that, in terms of the market kernel,
the value of an asset can be represented as

vi =

1 X
yi q(s)(s)
1 + rf
S

.
We can rewrite this expression in a simpler manner as follows. In probability notation,
X

yi q(s)(s) = E [yi q]

In the above expression E [.] represents expectations taken with respect to the probability measure . Next note that
X

q(s)(s) = E [
q] = 1

and that

E [yi q] = E [yi ]E [
q ] + COV [yi , q] = E [yi ] + COV [yi , q]

This yields the following valuation expression

vi =

E [yi ] + COV [yi , q]

1 + rf

In the valuation models developed in earlier finance classes, you probably used risk adjusted
discount rates to value securities, that is, you used the valuation equation

(RiskAdj.)vi =

E
1 + ki

where ki is the risk adjusted discount rate for security i (looks easy an easy way to value firms
until you try to figure out the risk adjusted discount rate!). Now, let Ri represent the return on security
i, that is,

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

yi vi
Ri =
vi
Note that (Risk Adj.) implies that ki = E [Ri ] and kM = E[RM ], where RM represents the
return on the market portfolio. Using (a lot) of algebraic manipulations one can show that

ki = rf + (kM rf )

where

COV [Ri , q]
COV [RM , q]

We call this the generalized cost of capital formula. This looks just like the CAPM equation
except that the definition of is a little different. In fact, the CAPM equation for the cost of capital is
special case of this formula (let q = a bRM where a and b are any arbitrary constants, and you will get
the CAPM). This shows that the state preference framework generalizes the basic valuation concepts
you have developed in your earlier finance courses. At the same time its conceptually a much simpler
framework. It is just this sort of simple framework we will need when we tackle the tough problems in
corporate finance.
Summary: Valuation using a state price vector is a generalization of the valuation techniques
you have learned in earlier finance classes. It is possible to extract from state prices the familiar risk
adjustment and time-discount factors used in your earlier finance courses. In fact the standard CAPM
can be views as a special case of the state preference model.

5.
5.1.

Consequences of Competitive Financial Markets

Irrelevance of capital structure changes that dont effect total cash
flows

The most famous consequence of competitive capital market, without corporate taxes, the firms
capital structure is irrelevant. To see this, let X(s) 0, be the state contingent cash flows of a firm, and
let F be the face value of of its outstanding debt. It follows that, in any state s, the payments received
by the equityholders of the firm can be represented as
Eq (F ) = max[X(s) F, 0]
and the payment received by the bondholders can be represented as
D(F ) = min[F, X(s)]
.
Note that

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

(TOT)
Eq (F ) + D(F ) = X

This equation just says that all cash flows goes to either debt or equity. The value of an unlevered
firm, which is the value of the firms equity when F = 0, can be represented as follows:
X
VU = V [X] =
X(s)p(s),
S

where VU is the value of the unlevered firm. The value of equity of a levered firm, VE , can be
represented by
X
VE = V [Eq (F )] =
max[X(s) D, 0]p(s)
S

and the value of the debt of a levered firm, VD , can be represented as

X
VD = V [D(F )] =
min[F, X(s)]p(s)
S

,
It follows then, that the value of a levered firm, VL , can be represented as the sum of the value
of its equity and the value of its debt, i.e.,
VL = VE + VD = V [Eq (F )] + V [D(F )]
But in a competitive capital market, value additive holds, that is
V [Eq (F )] + V [D(F )] = V [Eq (F ) + D(F )]
(TOT) shows that Eq (F )+D(F ) equals X and is, thus, independent of the firms capital structure.
Thus,
VL = VE + VD = V [Eq (F )] + V [D(F )] = V [X] = VU
This implies that, the value of a levered firm is equal to the value of an identical but unlevered
firm. This is a very intuitive result because it shows that, in perfect markets, all the leverage decisions
does is redistribute cash flows between the firms claimants, while leaving the cash flows unchanged. It
follows, therefore, that the value of the firm should remain unchanged too. The first major implication
of a competitive capital market is that
changes in the firms financial structure which dont change the firms total cash flow cannot
change the firms total value
that is, repackaging cash flows, cannot generate any real economic gains.

10

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

6.

Universidad de Chile

Investment Policy in Competitive Financial Markets: Always Maximize NPV

The second important consequence of competitive capital markets is that corporate investment
policies should be based on a single, simple principle: maximize NPV. To see this, consider, as always,
a two period economy. A firm has asset-in-place which will produce a cash flow of A at the end of the
period. The firm can also invest I dollars in an investment project which will produce a cash flow of
B(I) at the end of period. Suppose the firm does not have any cash on hand to finance the investment
and, moreover, the firm plans to invest all funds raised in the project. Then, if it is to invest I, the firm
will have to raise I from outside investors. In order to raise funds, the current investors will have to give
the outside investors some of the firms cash flows. Suppose that the security issued to outside investors
promises a payment of S(A, B), where S(A, B) denotes the fact that payment is dependent on the cash
flows realized by A and B. An example of such a security is equity, in this case

S(A, B) =

Nn
(A + B)
N0 + Nn

where Nn is the number of shares sold to new shareholders and N0 is the number of shares
outstanding before the security issue.
Suppose that the goal of the firm is to maximize the wealth of the original time 0 owners of the
firm. Their wealth will equal the value of their share of the firms cash flows. Since the outsiders are
going to get S(A, B), the cash flow to the insiders is the total firm cash flow (A + B) less the outsiders
claim S(A, B) and is, thus, given by
V [(A + B(I)) S(A, B(I))]
By value additivity, V [(A + B(I)) S(A, B(I))] = V (A) + V (B(I)) V (S(A, B(I))). In a competitive capital market, the market value of the outsiders clam, V (S(A, B(I))), must exactly equal the
amount they pay for the claim, I. In order words, in a competitive capital market the following crucial
identity holds.
V (S(A, B(I))) = I

Using this equality in the above expression, we see that

V (S(A, B(I))) = V (A) + V (B(I)) I

If the project is not undertaken, the original owners will receive

V (A)
Thus, the project should be undertaken if and only if
V (B(I)) I > 0
that is, if and only if the project has a positive NPV. Notice that both the risk-return characteristics of the firms existing assets and the form of financing (in this case represented by S(.)) are

11

Facultad de Economa y Negocios

Arturo Rodriguez-Andr
es Araya

Universidad de Chile

irrelevant to the investment decision. All that matters is the projects net present value. Thus, the second important consequence of competitive capital markets is that
An investment should be undertaken if and only if its net present value is positive
The firms existing financial condition, and its existing asset base, are not relevant to the investment decisions.
Question: Explain why each of the following argument is incorrect for a firm operating in a
competitive capital market:
Faulty Argument 1: Project x is a great project, but our company is facing a real cash flow
shortfall so we just dont have the funds necessary to undertaken the project.
Faulty Argument 2: Project x might be a good project for a firm with a lower cost of capital
to undertake but, given our high cost of capital, we should not undertake the project.
Faulty Argument 3: If we finance project x with security a, we will be much better off than
if we finance with security b. You see, a pays a coupon payment in the period before it matures, and
it also has a conversion option that b does not have. Thus, investors will require a much lower rate of
return on a than they will require on b and this will lower our capital costs.
Summary: In competitive capital markets there are no opportunities to profit from financing
decisions. All profits flow from operating policies. The only thing that matters is that you adjust your
financing policies so that you always have enough financial resources to take on all positive net present
value projects.

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