Chapter 4:

State Preference Theory

Contents
• Optimal choice when investing in a portfolio of more than 1 asset
• Vs. Topic 3: Choose one asset

• Problem: Optimizing portfolio based on initial assets and risk appetite.

• Assumption: Perfect capital market (transaction fee = 0)

•
Uncertainty and Alternative Future States
• A security can be thought of as an asset class that will yield
different results in different states of the economy in the
future.
• 1 stock = 1 possible future vector
• Example: VNM yield = (-10%, 3%, 40%) depending on the state of the economy.

• A row vector

• 1 category = 1 possible future matrix

• Each stock has a row vector

• Each state has a column vector

Uncertainty and Alternative Future States
• Investor's perspective:
• Each held security carries a claim and that interest depends on the future state
of the security.
• Each state that occurs in major securities is usually the state of the economy.

• When a position materializes, the interest of a particular security is determined.

• No limit on the states of the economy  no limit on the output of securities.

However,
• The states do not occur simultaneously and in the state vector, either one will occur. (Mutually exclusive and exhaustive)
Uncertainty and Alternative Future States
• Assumptions for investors
• The probability of each state of the security is the probability that the
corresponding state of the economy will occur.
• Investors only care about how much they have when a certain position occurs.
Knowing that outcome, they are not concerned with the possible outcomes of
other states
Pure Securities
• The security has a value of $1 at the end of the period if a
certain position occurs and $0 if the position does not occur
• Each state has an underlying security.
• Purpose: Add securities portfolio to a combination of
underlying securities in different states.
States of economy Security payoffs (Returns /Prices) Chứng khoán

Prosperity High Each security has a feature vector

Normalcy Medium of the probabilities and outcomes
of the states
Recession Low
Crisis 0
Complete Capital Market
• The capital market is complete when the number of positions is equal to the
number of securities and individual and independent securities
• Securities exist independently and are not dependent on each other

• For example:
• Assume there are 3 states in the future. If there are only 3 assets in the market (1,1,1), (1,0,0) and (0,1,1),
this capital market is incomplete.
• (1,1,1) risk-free assets (1)
• (1,0,0) unemployment insurance claim (2)
• (0,1,1) corporate bonds (3)
• 1 = 2+3 (1st order relation) => not independent => Incomplete market
Complete Capital Market
• What if it's not complete?
• impossible to create a number of new securities from those in the incomplete market.
• For example, (1,1,1) (1,0,0) and (0,1,1) do not produce (0,1,0). Then (0,1,0) can exist many different
values, not identical.
• If there is one more (0,1,3), 4 securities will create a complete market.

• How to create triples (1,0,0), (0,1,0) and (0,0,1) , from the above 4 securities?

• If the market is perfect, it is possible to create any security (a,b,c) from the above
3 types of securities.
• Example buy/sell short security a (1,0,0), b (0,1,0) and c (0,0.1)
Complete Capital Market

Long 3 security 2, short 1 security 3 → (0,2,0) →(0,1,0)

Long (0,1,1) short (0,1,0) → (0,1,0)
(1,0,0), (0,1,0), (0,0,1) create a complete capital market
Pure security prices
Pure security prices
• Solve the system
Non- arbitrage profit condition
• In the complete market, any portfolio can be described by a
combination of pure securities,
and the price of the portfolio is equal to the price of that combination of
securities.
• If short selling is allowed and transaction cost is zero 

=> All arbitrage opportunities are eliminated.

Economic determinants of security prices
Economic determinants of security prices
• 3 factors: (1) time preferences for consumption and productivity of capital , (2)
expectations as to the probability that a state will occur, (3) individuals’ attitudes
toward risk

time preference
Optimal Portfolio Decisions
• σ Π𝑠 𝑈(𝑄𝑆 ): 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙′ 𝑠 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑛𝑑 − 𝑜𝑓 − 𝑝𝑒𝑟𝑖𝑜𝑑 𝑤𝑒𝑎𝑙𝑡ℎ
• QS: number of securities paying $1 if state s occurs.
• (number of state s pure securities he buys)
• (his end-of-period wealth if state s occurs)
• How much of W0 to spend for current consumption C?
• What portfolio to hold for the future?
• Solve the problem:
Với điều kiện
u(c): consumption
+ invest ment (Utility of each limited w= consump+ sum of pay off
scenario) x n ( probs)
Optimal Portfolio Decisions
• Phương pháp nhân tử Lagrange (Lagrange multiplier)
Optimal Portfolio Decisions
Optimal Portfolio Decisions
• Với mọi trạng thái t và s
trong tương lai