FINANCIAL ECONOMICS

Lecturer： Quyen Do Nguyen, PhD

Corporate Finance Department
Faculty of Banking and Finance
Foreign Trade University
Email： quyendn@ftu.edu.vn

Course Materials: https://www.dropbox.com/sh/bhbsaz4t8ehyk50/AADaldsAfMk

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CHAPTER 4: STATE PREFERENCE THEORY

Main content

 Optimal choice when investing in a portfolio that has

more than 01 asset
 Vs. Chapter 3: Choosing 01 asset
 Problem-solving: Optimize the portfolio based on initial
wealth and risk taste
 Assumption: Perfect capital market (transaction cost = 0)

One security model

 A security can be considered as an asset that brings about different

outcomes in different state of the economy in the future. 1 security =
1 vector/1 bundle of possible outcomes in the future.
 Eg:VNM’s return = (-10%, 3%, 40%) depending on each state of the economy.
 One vector row

1 portfolio = 1 matrix of possible outcomes in the future

 Each security has one vector row
 Each state has one vector column
 One security model

 From the investors’ view:

 Each security has one state-contingent claim and that claim depends on each
state of the claim in the future.
 Each
state of the claim is the same as each state of the economy.
 When the state occurs, the security claim is realized.

 No limit of the states of the economy  no limit of the outcomes of the

security investment. However,
 The states and the vectors of the states are mutually exclusive and exhaustive.

One security model

 Assumptions:
 The probability of each state of the security is equivalent to the probability
of each state of the economy.
 The investors only concern about how much they will get when a state occurs.
When the outcomes are known, they do not care about other outcomes in
other states of the economy.
Pure securities

 Pure securities take value $1 at the end of the period if that state
occurs and 0$ if other states do not occur.
 Each state will have one pure security.
 Objectives: Grouping securities into different pools of pure securities
of different states.
States of the economy Outcomes (Payoffs/Prices) Securities
Prosperity High Securities are defined by
Normalcy Medium patterns of payoffs under
different states.
Recession Low
Depression 0

Complete Capital Market

 A complete capital market is defined as a market in which the number

of unique linearly independent securities is equal to the total number
of alternative future states of nature
 The securities must be linearly independent
 Example:
 Suppose there are 3 states of nature and there are 3 assets as follows:
 (1,1,1) is a payoff of a risk-free asset (1)
 (1,0,0) is a payoff of an unemployment insurance contract (2)
 (0,1,1) is a payoff of risky debt (3)
 Question: Is this capital market complete?
Complete Capital Market

 1 = 2+3  no linearly independent relationship  Incomplete market

 So what???
 When the market is incomplete, any possible new security cannot be created
from the existing securities.
 Eg: (1,1,1) (1,0,0) and (0,1,1) cannot create (0,1,0). Hence (0,1,0) will not have a
unique price.
 Suppose we add another security (0,1,3), the market will become complete .
 How to create a portfolio (1,0,0), (0,1,0) và (0,0,1) from the above securities?
 If the market is complete, we can create any security (a,b,c) from the above
securities.
 i.e. long/short sell a (1,0,0), b (0,1,0) and c (0,0,1)

Complete Capital Market

1 0 0 1 0 0 1 0 0 1 0 0
0 1 1→0 1 1→0 1 1→0 1 0
0 1 3 0 0 2 0 0 1 0 0 1

Long 1 security 3, short 1 security 2

Short ½ security 3
Long 1 security 2, short 1 security 3
(1,0,0), (0,1,0), (0,0,1) create a complete capital market
Pure securities

 𝑝 prices of pure securities

 𝑝 prices of market securities
 𝜋 state probabilities – individuals’ belief about the relative
likelihoods of states occuring
 𝑄 number of pure securities

Caculate the prices of the pure securities:

Securities State 1 State 2 Securities prices

Identifying prices of pure securities

 Solving set of equations:
 No arbitrage condition

 Capital market equilibrium requires the market prices be set so that

supply equals demands for each individual security. 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.
 Ifshort selling is allowed and transaction cost is equal to 0  Any
arbitrage opportunities are eliminated.

Economic determinants of securities prices

𝜃 the price of an expected dollar payoff contingent on state s occruring

Economic determinants of securities prices
 3 determinants: risk free rate (time value), probability of states and
risk tolerance of investors + relative results of states

Optimal portfolio decisions

 𝑄 number of pure securities we buy for each state 𝑠 (pay $1 at the
end of the period for each security if state 𝑠 occurs)
 𝐶 current consumption
 In principle, u(C) and U(Qs) can be different functions

Subject to
 Optimal portfolio decisions
 Lagrange multiplier

Example

 Consider an investor with a logarithmic utility function of wealth

U(W)=ln(W) and initial wealth of $10,000. Assume a two-state market
where the pure securities prices are 0.4 and 0.6 and the state probabilities
are 1/3 and 2/3. Calculate the optimal consumption and investment
choices using Lagrange multiplier.
Optimal portfolio decisions

With a current state and 1 future

state 𝑡.

Optimal portfolio decisions

 With all states t and s
Practice exercise

Exercise 1:
Security A pays $30 if state 1 occurs and $10 if state 2 occurs.
Security B pays $20 if state 1 occurs and $40 if state 2 occurs. The
price of security A is $5 and the price of security B is $10.
a). Set up the payoff table for securities A and B.
b). Determine the prices of the two pure securities.

Practice exercise
Exercise 2:
Securities State 1 State 2 Securities prices
j $12 $20 𝑝 = $22
k 24 10 𝑝 = 20
i 6 10 𝑝 =?

a). What are the prices of pure securities 1 and 2?

b). What is the initial price of a third security i, for which the payoff
in state 1 is $6 and the payoff in state 2 is $10.