INTRODUCTION

State preference and mean-variance approaches are common to use for estimating risky assets
under uncertainty. In this paper, firstly mean variance and state preference approaches are
examined in terms of axioms, assumptions and consideration of characteristics of utility
functions, especially logarithmic utility function. Secondly, based on the argument of Kraus
and Litzenberger (1975), some theoretical methods will be provided to prove that mean
variance approach is considered as a special case of state preference approach. Lastly, the
paper discusses the pros and cons of both approaches.

STATE PREFERENCE THEORY
The basic idea under the state preference approach is that the uncertainty is captured by a
finite set of mutually exclusive future states of the world. By examining these alternative
states, investors decide their actions in terms of investment decisions such as trading and
portfolio optimization at the current time before the future state is occurred. In the next
period, only one state will occur and come up with the outcomes of the action corresponding
to that state. According to Sharpe (2005), a security can be seen as a set of possible payoffs
each occurring in different states of the world.
Axioms
Arrow and Debreu (1964 and 1959) states that the objects of customers choice are bundles
of commodities which probably state-contigent and time-contigent. If the ordering axioms are
satisfied then the preferences among these objects are illustrated by the utility functions (Nau
2011). Moreover, if independence axiom is implied, the preferences between two state-
contingent commodity bundles are independent of elements they have in common, the utility
function has an additive structure and is cardinally measurable and can be given a subjective
expected utility interpretation (Nau 2011).
Ordering axioms:
Completeness axiom : if x, y e X either x y or y x
Transitivity axiom : x, y , z e X; if x y and y z then x z
Continuity axiom : Continuity axiom says that if x is preferred to z, and y is a bundle
which is close enough to x, then y will be preferred to z.
Independent axiom:
Let p, q, r and oe (0, 1) then pq if and only if op + (1-o)r oq + (1-o)r
In other words, if each of two lotteries is mixed with a same third one, the independence
axiom says that the third lottery will not affect the preference ordering between the other
two. If the ordering and independence axioms are satisfied, then the preference can be
illustrated by a utility function. Outcomes are numerical shown as utilities U
i
. Expected
utility is the sum of all possible outcomes of choice weight the outcome proportions (p
i
)
( )
i i
i
E U pU =

Some further axioms
Monotonicity : The preference for any two bundles x and y are monotone if
i i
i i
x y for each i
x y for each i
>
>
implies u(x) > u(y)
Under monotonicity axiom, the indifferent curves are described as downward sloping
trends. This indicates that the budget will be spent by an agent.
Convexity: When x y then tx + (1 t)y y for all t e [0,1]
Convexity axiom is important in analysing the problem of utility maximization.
Assumptions: The two most important assumptions in state preference approach are the
completeness of the market and no-arbitrage.
Completeness of the market
Complete market is a critical assumption under Arrow-Debreu theory. According to
Hens (2004 p.151), a market is called complete when all consumption streams in the
second period can be attained by trading assets; in contrast, the market is incomplete
when there is some second period consumption streams cannot be achieved. This
assumption insures all consumption plans and allows the price of these plans to be
defined uniquely (Hens 2004 p.151). Under mathematical aspect, the market is
complete when the rank of the return matrix R equals to the number of states S.
No arbitrage
No arbitrage condition is considered that all securities lying on the same plane of risk
should have the same price. In other words, trading with arbitrage opportunity
provides riskless profit coming from zero net investment payment and zero net risk.
Arbitrage opportunities cannot be existed in equilibrium because they will conflict
with the assumptions that make to find an optimal portfolio (Hens 2004, p. 153). With
the same level of payoffs, any different combinations of assets should have the same
price. This is called Law of One Price. The asset pricing process is under some
restrictions implied by the non-existence of arbitrage opportunity. Hens (2004, p. 153)
argues that the requirement of Law of One Price is that the prices of asset are linear
which means when all payoffs are doubled, the prices are also doubled.
Under completeness of market and no arbitrage opportunity, the law of one price must
hold and any securities can be priced by discounting their payoffs with respect to the
state prices (Hens 2004, p. 85).
Logarithmic utility function
Merton (1974) argues that mean-variance approach is consistent with expected utility
approach when either expected utility function is quadratic or security prices are normal
distribution; however from empirical work it shows that this model does not fit the true data.
Moreover, even the increase in interest regarding to the families of utility functions with
constant relative-risk aversions or constant-absolute-risk aversions, the utilities in real life
could not rely on a simple form of model (Merton 1974). The logarithmic utility function
with diminishing marginal utility is shown to be more precise in describing customer
behavior in real life business.
Under logarithmic utility function, the absolute risk aversion decreases. This means when the
payoffs become larger, the shape of the utility function becomes less curved. In other words,
at a higher level of payoffs investors are more willing to take risk, while at lower level of
payoffs they are inclined to adverse risk (Rachev 2011). Merton (1974) supposes that if the
logarithmic function is valid, the distribution of true portfolio could be lognormal in terms of
E(log W
T
) and Var(log W
T
). The expected average compound return along with the variance
of average compound return could be given for the first time a true legitimacy for all persons
with / U W

= (Merton 1974). Merton (1974) shows that this is hold if either 1- is

positive number or is large negative number; but if is far from zero, then it leads to the
bad result.
Explain the quote of Hirshleifer (16, p.277)
In reality, besides the uncertainty of the market, the preference of each agent is different and
the way they examine and forecast future states of the market are also not identical. Thus,
depending on their freedom in choosing the level of bearing risk, different types of utility
functions, representing different types of risk aversion, could be applied. While linear
function provides risk aversion =0 (risk neutral), square root function and logarithmic
function have risk aversion =1/2 (risk seeking) and =1 (risk averse), respectively.
MEAN VARIANCE ANALYSIS
The analysis is developed by Harry Markowitsin 1952 and this is a method for the investor to
select the optimal portfolio based on the tradeoff between risk and return. Specifically, mean
variance analysis relies on the mathematic to calculate the risk and return of particular
portfolios to determine which one has the highest return with the same risk
Assumption of Mean variance analysis
- Investors are risk-adverse and they prefer highest return for a give level of risk.
However, the levels of risk adverse varies between investor
- Investors are well-known about the expected return, variance, standard deviation and
covariance
- No transaction cost and tax. There is no change in the net wealth of investor they buy
x dollar value of any asset and immediately sell it. If there is a transaction cost,
investor will face a non-zero net cost.
- Investor is allowed to purchase any amount of asset, positive or negative amount.
Owning a negative amount of risky asset is called short sell whereas a negative
amount of risk free asset is called borrowing. An amount of shares do not required to
be an integer
- Investor is a price taker which means the action of buying and selling asset cannot
affect the price. Price is the same for both long and short position
According to Pulley (1981), mean variance analysis require a quadratic utility and its return is
normally distributed that is consistent with four axiom of expected utility theory are
completeness, transitivity, independence and continuity. However, Adler and Kritzman
(20045) criticise that returns are not perfectly normally distributed and because investor
preference do not conform precisely to quadratic utility. Logarithmic utility function
(growth optimal) is chosen to help the mean variance model to justified and its
mathematical and computational advantages can continue to be successfully exploited.

Return normal distribution and quadratic utility
According to the article Mean variance analysis (n.d), an individuals expected utility will
be ((

))

) where (

) is the variance of the return on the portfolio.

As a result, quadratic utility leads to expected utility rely only on the mean and variance at
any given probability distribution. However, if the utility is not quadratic, we need a
distribution where the return on a portfolio has a distribution that rely only on mean and
variance and the distribution satisfy that condition is normal distribution. Such distribution
makes expected utility rely on the mean and variance of portfolio return. This is because
*(

])

+ for n odd and *(

])

((

])

for n even. Hence,

individual expected utility will be
[(

)] ([

])

([

])

([

])

(
[

)
([

])

(
([

])
This is why mean variance analysis require return normally distributed and quadratic utility
function
Logarithmic Utility
Regarding the growth optimal, Ziemba and Zhao (2002) stated that Merton (1973, 1992)
showed that the growth optimal portfolio is instantaneously mean variance efficient when
asset prices are log-normal. However, the Markovian state price density process must control
the asset price behaviour in order to hold the intertemporal CAPM as the growth optimal
portfolio behaves as the market portfolio. By proving all portfolios created from maximizing
expected utility of terminal wealth on the efficient frontier, the growth optimal portfolio is
regarded as the risky mutual fund. As a result, Investor will be indifferent between two
mutual fund, combination of market asset, growth optimal portfolio and riskless asset.
Proof: Mean variance analysis is a subset of State Preference Theory
The mean-variance approach may be viewed as a special case of the state preference model.
There are quite four assumptions, which considered being reasons for mean-variance
approach to be a subset of state preference model: normal distribution, incomplete market,
and levy process with jump diffusion and logarithmic utility.
First of all, this report examines special case of either quadratic utility or normally
distributed returns on securities.
It is a given theoretical statement that the general expected utility function constructed in
state preference theory is dependent upon the entire distribution of returns. Beside, mean-
variance analysis can be a special case when utility function depends on only the mean and
variance of the distribution. Theoretically, Investors have preferences over returns and this
determines preferences over states. The expected utility that investors act to maximize
according to state preference approach can be:
1 2 1 2
1 1 1 2 1 2 1 2 2 2
( [1 ] [1 ]) ( [1 ] [1 ]) EU pU a r a r p U a r a r = + + + + + + +
(p
i
is the probability of each state i occurs and a
i
is the investment in asset) then with the case
of each possibility occurring with probability we have the amount that the risk-averse need
to pay is base on:
| | ( ) | | ( )
( ) 1 1 U M U M r U M r = + +
(Which is the risk premium) and an assumed income of M: the more risk averse the
investor is, the more the investor will pay).
Indifference curves from expected utility function:
EU = pU(W - a + a[1 + r
g
]) + (1-p)U(W - a + a[1 + r
b
]) when W is the amount to invest, and
a is the amount to invest in risky asset, r
g
is return in good state and r
b
is return in bad state).
Thus, more wealth will be invested if good states occur and less wealth with bad states,
amount to invest in risky assets (a), which maximizes the expected utility, will be chosen. As
we can see, the general expected utility function constructed in state preference theory is
dependent upon the entire distribution of returns. On the other hand, when we come to an
analysis of mean- variance approach, the investors preferences are assumed to be defined in
terms of the mean and variance of the asset returns which implies that expected utility can be
expressed as EU(x) = W(M, V), where M = E(x) and V = Var(x). Moreover, this will be hold
only with the requirement of either quadratic utility or normally distributed return on
securities.
Assume the investor has preferences over wealth in each state described by the utility
function U= U (W). Denote the level of wealth by taking a Taylor's series expansion of
utility around expected wealth:
( R
3
is the error term)
With the requirement of either quadratic utility ( = 0 with n>2) or normally
distributed return on securities, expected utility will be:
W
~
( )
| | ( ) W E U
n
~

In the perspective of an investors portfolio selection problem, a risk-averse investor will
choose among mean-variance efficient portfolios which providing the highest mean portfolio
return for a given variance. This also depends on the level of risk-aversion of investor.
Furthermore, since an individual is able to choose which assets to combine into a portfolio,
all portfolios created from a combination of individual assets or other portfolios must have
distributions that continue to be determined by their means and variances then the return on a
portfolio of these assets has a distribution that depends on just mean and variance. The only
distribution that satisfies this "additivity" restriction is the normal (Gaussian) distribution. A
portfolio of assets whose returns are multivariate normally distributed also has a return that is
normally distributed.
Note: In the case of normally distributed wealth, we can write
| |
2
2
1 ( )
( ) ( ) exp
2 2
( ) ( )
( , )
W
E U W U W dW
U W W dW
V

o to
o |
o

=
`
)
= +
=
}
}

Under a quadratic utility function, maximizing expected utility is equivalent to maximizing a
mean- variance reference function Wealth (Mean, Variance).
2
2
2 2
[ ( )] ( ) ( )
2
( ) [ ( ) ( )]
2
( )
2
( , )
b
E U W E W E W
b
E W Var W E W
b
V
o
o
=
= +
= +
=

Secondly, both two approaches: mean-variance and state preferences come up with
logarithmic utility.
( ) | | | | ( )
|
.
|

\
|
=
2 ~
,
~ ~
W W E U W U E o
As the revival by von Neumann and Morgenstern, maximization of the expected value of a
concave utility function of outcomes has been a general criterion for optimal portfolio
selection. However, the mean-variance criterion is consistent with the general expected-utility
approach only in the rather special cases of a quadratic utility function or of Gaussian
distributions on security prices or normal distribution. Since the mean-variance model has
interest because of its separation property or Mutual-fund Theorem holds regardless of the
probability distribution of return, thus it is come up with CRRA and CARA utility function
form (Merton- HARA utility). However, this may be exact in the reality only when the risks
are small. Also, the Central Limit Theoremreturns over longer periods would be lognormal
distributed. Indeed, as returns over longer horizons are the product over short horizon returns,
the central limit theorem can be evoked to the sum of the logs of short run returns.
Furthermore, Merton ( 1971) extends his earlier results to more general utility function:
regards to problems of mean-variance results in discrete time are justified by either
multivariate normality of security returns ( which is inconsistent with limited liability) or
quadratic utility ( which is inconsistent with nonsatiation beyond some level of wealth and
implies increasing absolute risk aversion), Mertons key results is to show a scenario in
which optimal portfolio choices can be reduced to choices over mean and variance:
(i) All security returns follow geometric Brownian motion: they are lognormal over
all time intervals, and
(ii) Consumer/investors trade in continuous time.
As consequence, those above factors support it is believed that investor can replace an
arbitrary utility function of terminal wealth with all its intractability, by the function U( W
T
)
= log( W
T
) : logarithmic utility or maximizing the geometric mean or the expected log of
outcomes would provide an asymptotically exact criterion for rational action, implying an
efficiency of a diversification-of-portfolio strategy constant through time for every period,
even when probabilities of different periods were interdependent. The reason is that with
logarithmic preferences the utility of terminal wealth is simply the sum of the utilities of
single-period portfolio returns. If a random variable is log-normally distributed
(log(X)N(,) ) then the higher variances, the higher are expected returns. In other words,
increasing the variance is equivalent to shifting more weight on the right side, which
increases the expected value of returns.
While, it is known that state preferences approach is assumed to have logarithmic utility
(time-state-independent logarithmic utility function: Hakansson), which allows consideration
of trading in all intermediate periods with no specification of return distributions. Thereby,
mean-variance approach can be seen as a subset of state preference model.
Lastly, we have a glance at the case of incomplete market, i.e., levy process, jumps or
diffusionthe existence of so called fat tails Spremann [2008] notes compared to the
shape of a normal distribution as we observe too many extreme observations on the left and
right side of the distribution or the probability triangle with mean-variance preferences which
are not linear. In the case of incomplete market in which the number of securities is less than
the number of states of nature, there will be no unique measure of risks, which also implies
that the probability will change from a p to a family distribution of Q. This particular case
with no measure of risk requires complex mathematical analysis also support the conclusion
that mean-variance is convinced to be a special case of state preference model.
Identify other Utility function/functions and return distributions that
satisfy the state preference theory:
- Quadratic utility function
- Exponential utility function

- Constant elastic utility function
- Power log utility function
Pros and cons between state preference theory and mean-variance analysis.
State preference theory
The state preference model helped to explain a number of unresolved controversies such as:
the nature and extent of risk aversions, whether there is an optimal debt-equity mix in
financing corporate undertakings (the Modigliani- Miller problem), and the appropriate rate
of discount to employ in cost-benefit calculations for government investment not subject to
market test (Hirshleifer, J 1966, pp.253). Followed by Robert Bowman (1975), Hirshleifer
has used this theory to provide important perceptions to areas such as production and
exchange, investment decisions, and speculative behaviors. Myer (1968) believes that the
theory is useful for explaining security valuation.
Furthermore, referred from Kerruish (2007), one of the most interesting uses of the state-
preference model which was developed by Kraus and Litzenberger (1973) could be used to
construct optimal capital structure and bankruptcy cost. The main advantages of the state
preference approach is that it is a useful tool to make decision under uncertainty, it provides a
conceptual basic for developing analytical models that provides significant insights such as
question of optimal capital structure. Additionally, it supports both the individual investor
and analyst who are seeking to strengthen his conceptual and analytical model.
However, similarly to all financial models, the state preference approach has some
disadvantages. Hirshleifer (1966) proved that when markets were imperfect, there would be
an optimal debt/ equity ratio therefore the time-state-preference model could be vague.
Nevertheless, Myer (1968) stated that this vagueness was unavoidable if we were not
assume markets were perfect. Besides, the state preference model has been highlighted by
several scientists as an analytical tool, rather than an empirical one such as for capital
budgeting from the work of Bredeen and Litzenberger (1978).

Mean-variance analysis:
According to Newbery (1988), the mean-variance model is attractive for the analysis of
equilibrium in securities markets as it gives rise to linear asset demand functions. The
approach is not only convenient but its formula is also easy to interpret. Newbery found out
that this approach was tractable for modeling of future markets equilibrium and comparative
statics. Followed by Bigelow (1993), the mean-variance analysis was suggested by Meyer
(1987) as a device of simplifying the theory of decision making under price uncertainty.
Besides for the analysis of equilibrium in securities markets, the mean-variance analysis is
also applied for other decision making contexts such as selecting and ranking product designs
because the performance of a product is based on many source of variations (Liu, 2004).
According to Zhao and Zhiemba (2002), the mean-variance criterion had a better
performance if the outcome of the market state price was near its mean value. Liu (2004)
showed that with unlimited short selling and risk free assets and without restriction on
preference, we should use parameter-based model to rank if the portfolios were stable and
mean-variance model if the portfolios were normal. Furthermore, Pulley (1983) found the
mean-variance approximations to be strong for different holding period, different ration of
noninvested to invested wealth, and different subjective return distributions, including non-
normal distributions.
Despite of being the basis of most existing portfolios and capital asset pricing models, the
mean- variance approach has been criticized. The analysis is restricted to static models
according to Zhao and Zhiemba (2002). Follow by Pulley (1983), this approach has
restrictions since it requires quadratic utility or normally distributed security returns to be
consistent with the axiom of expected- utility hypothesis. Moreover, Liu (2004) showed the
invalidity of the approach. The paper suggested that if the first order dominance was the
criterion of validity, the mean-variance model would not be valid to rank arbitrary
distributions and its extension involving movements of higher order did not help improve the
validity.

CONCLUSION
To sum up, this paper has presented the mean variance and state preference regarding to their
axioms, assumptions and characteristics of utility functions in special case of logarithmic
utility function. Following the argument of Kraus and other theoretical methods, mean
variance approach is proved to be a subset of the state preference approach. This paper also
indicates the pros and cons of the two approaches. These lead to the fact that agents choosing
the model for pricing assets under uncertainty depend on their unidentical preferences and
level of risk aversion.

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