Axioms and Assumptions Behind the State Preference Theory and Mean-Variance Analysis
State preference theory is the most general approach to select risky assets under uncertainty. Critically discuss this approach using the following reference:
? Kraus A and Litzenberger R H, Market Equilibrium in a multi-period state preference module with Logarithmic Utility, The Journal of Finance , Vol xxx, No 5, December 1975, pages 1213- 1227.
Each student in the group (minimum of 4 maximum of 5 in each group) must clearly identify individual contributions towards the group project. The marks are proportional to the contributions from each student.
Individual project reports will not be accepted.
In your project report you need to argue that:
? Explain the following statement that is made in the Introduction of Kraus & Litzenberger (1075), page 1213: the absence of a natural, agreed upon, and manage-ably small set of state definitions puts severe obstacles in the way of examining data about observable security behavior in terms of underlying choices for sequences of time state claims- explain it. (Lecture in Week 5 will guide you).
Hint: Probability distribution
> As a result you should examine all the axioms and assumptions behind the state preference theory and mean-variance analysis (use the knowledge you have gained from lectures in Week 1 to 4)> The mean-variance approach may be viewed as a special case of the state preference model, requiring either quadratic utility or normally distributed returns on securities. Examine the theoretical characteristics of the utility function in the mean-variance approach and the state preference model with logarithmic utility suggested by Kraus & Litzenberger (1975).
Hint: We already know properties of the logarithmic utility function due to Kraus & Litzenberger (1975), so there is no need to explain this in great detail.
> Identify any other utility function/functions and return distributions that satisfy the state preference theory and discuss pros and cons between state preference theory and mean-variance analysis. This will require additional literature review/ literature search. Please include your reference/s in the main body of the report and provide the reference list at the end of the report.