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FINECO 04 State Preference Theory

Here are the solutions to the practice exercises: Exercise 1: a) Security A B State 1 30 20 State 2 10 40 b) Pure security 1 = $15, Pure security 2 = $25 Exercise 2: a) Pure security 1 = $16, Pure security 2 = $6 b) The price of security i is $8

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87 views

FINECO 04 State Preference Theory

Here are the solutions to the practice exercises: Exercise 1: a) Security A B State 1 30 20 State 2 10 40 b) Pure security 1 = $15, Pure security 2 = $25 Exercise 2: a) Pure security 1 = $16, Pure security 2 = $6 b) The price of security i is $8

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FINANCIAL ECONOMICS

Lecturer ： Do Duy Kien, PhD


Foreign Trade University, HCM Campus

Email ： doduykien.cs2@ftu.edu.vn

Copyright (ppt slides): Quyen Do Nguyen, PhD


Faculty of Banking and Finance
Foreign Trade University
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 Securities
(Payoffs/Prices)
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

100 10 0 100 100


  

0 1 1→0 1 1→0 1 1→0 1 0


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

013 00 2 001 001


Pure securities

  prices of pure securities


 prices of market securities

 state probabilities – individuals’ belief about the relative

likelihoods of states occuring


 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.
 If short selling is allowed and transaction cost is equal to 0  Any
arbitrage opportunities are eliminated.
Economic determinants of securities prices

 
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
  number of pure securities we buy for each state (pay $1 at the end of
the period for each security if stateoccurs)
 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 .
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 = $22
k 24 10 = 20
i 6 10 =?

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.

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