Tutorials Chapter 3 State Preference Theory

Exercise 1
The following information is available for two market securities:

Payoff
Security State 1 State 2 Security Prices
j $12 $20 Pj = $22
k $24 $10 Pk = $20

(a) What are the prices of pure security 1 and pure security 2?
(b) What is the price of a third market security i, for which the payoff in state 1 is $6
and the payoff in state 2 is $10.

Exercise 2
Individual has an initial wealth of $1000 and it is assumed that three states can prevail in the
future, with probabilities: 0.3, 0.5 and 0.2. The prices paid for the market securities M, N and
O are equal to $0.9, $4.3 and $2.8 respectively and their respective pay-offs are as follows:

1 4 3

M= 1 N= 7 O= 4
1 3 2

(a) Under what conditions can the payoff of a market security be replicated by the
payoff of a portfolio of pure securities? Explain how each of these conditions is
determined.
2 assumptions:
(i) Market must be complete, i.e. the number of states should be equal to the
number of linearly independent securities. E.g. if there are 3 states, there should
be 3 linearly independent securities.
(ii) There should be no arbitrage opportunity opportunities; i.e. two securities
offering the same payoff should have the same price. The price of a market
security and a portfolio of pure securities offering the same payoff should be
equal.
(b) Calculate the prices of pure securities.

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 (c) Assume that U (X) = log (X). Using the Lagrange multiplier method, solve for the
optimal levels of consumption and quantities of pure securities.
(d) Assume that U (X) = X1/2. Solve for the optimal levels of consumption and
quantities of pure securities.
(e) Compare and comment on the results that have been obtained in parts (d) and (e)
of this question.
Individual with logarithmic utility function (concave function) is averse
towards risk and consumes (Rs500) today and individual with function
X1/2 (convex function) will consume a relatively smaller amount of wealth
(Rs442). Individual who is averse towards risk prefers to consume a
higher amount today and invests a lower amount (Rs500) in the risky
security; as compared to individual who is attracted towards risk and
who will invest a higher amount (Rs558) in the risky securities.