CHAPTER FOUR

STATE PREFERENCE THEORY

Chapter Overview

Introduction
Uncertainty and Alternative Future States
Pure Securities
Complete Capital Markets
Derivation of Pure Security Prices
No-Arbitrage Profit Condition

CHAPTER FOUR
STATE PREFERENCE THEORY
Chapter Overview Continued

Economic Determinants of Security Prices

Optimal Portfolio Decisions
The Efficient Set with Two Risky Assets
Firm Valuation, the Fisher Separation Principle, and
Optimal Investment Decisions

Introduction
Chapter Objectives
Understand the fundamental role which securities play in
permitting intertemporal shifts in consumption
To expand on the discussion of the previous chapter by
addressing the more general matter of portfolio decision
making and explaining how optimal individual and firm
investment decisions are determined under uncertainty

Uncertainty and Alternative

Future States
The State Preference Model
The State Preference Model is an excellent place to
begin our more in-depth discussion of securities and
security prices
Keep in mind that the model assumes a perfect capital
market in order to ensure that there are no costs of
portfolio construction

Uncertainty and Alternative

Future States
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
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
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Uncertainty and Alternative

Future States
An Example of the State Preference Model

Definition of Pure Securities

Generalizing the Model
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 $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 portfolios of
various pure securities
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No-Arbitrage Profit Condition

Arbitrage and Capital Market Equilibrium
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 statecontingent payoff vectors must be priced identically
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

Arbitrage and Capital Market Equilibrium
If both securities or portfolios are in positive supply, such
prices clearly cannot represent an equilibrium
This condition is called the single-price law of markets

No-Arbitrage Profit Condition

Arbitrage and Capital Market Equilibrium
Now, if short-selling is allowed in the capital market, we can
obtain a second related necessary condition for market
equilibriumthe absence of any riskless arbitrage profit
opportunity
This no-arbitrage condition requires that the price of the
market security be equal to the price of any linear
combination of pure securities that replicates the market
securitys payoff vector

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Optimal Portfolio Decisions

The Basics

max u (C ) sU (Qs )
s

Subject to

p Q $1C W
s

Maximizing our expected utility of current and future

consumption subject to our wealth constraint

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Optimal Portfolio Decisions

The Basics
Solve using the Lagrange multiplier
method

L u (C ) sU (Qs )
s

psQs $1C W 0
s

LM = = Measure of how much our utility

would increase if our initial wealth were
increased by $1

Optimal Portfolio Decisions

The Basics
Solve for optimal choice of C and Qs
L
u ' (C ) $1 0
C
L
tU ' (Qt ) pt 0
Q1
L

p Q $1C W
s

The Efficient Set

Two Risky Assets and No Risk-Free Asset
Important portfolio optimality conditions for any risk
averse expected utility maximizer

tU ' (Qt ) pt

u ' (C )
$1
tU ' (Qt ) pt

sU ' (Qs ) ps

for any state t

for any two states s and t

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The Efficient Set

Two Risky Assets and No Risk-Free Asset
Important portfolio optimality conditions for any risk
averse expected utility maximizer

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The Efficient Set

Two Risky Assets and No Risk-Free Asset
Important portfolio optimality conditions for any risk
averse expected utility maximizer

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The Efficient Set

Portfolio Separation
Investors portfolio choices over risky securities are
independent of their individual wealth positions
Investors choose among only a few basic portfolios of
market securities
Greatly reduces importance of having a complete market
In a special case, the security pricing relation can be
expressed in terms of mean and variance and is called
the capital asset pricing model (CAPM)

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Firm Valuation
Addressing Valuation, Separation, and Optimality

Given uncertainty, the principle of Fisher Separation still

holds so long as capital markets are 1) perfectly
competitive and frictionless and 2) complete
If these conditions are met, the firms actions affect
shareholders expected utility only by affecting their
wealth through changes in the firms current share price

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