The Traditional Theoretical View of Preference Theory

Abstract

This paper reviews the State preference theory from a traditional perspective. It explains the model under which the state preference theory and gives rigorous explanations of the assumptions and their normative explanations.  The paper goes further to reflect its focus on the state preference framework and also explains the aspects of state prices and their relation to aggregate wealth. The paper gives a technical view of risk neutral valuation in relation to state preference theorem, insights that allows for transforming of the state prices into a common discount factor known as risk neutral probabilities. The paper looks touches on a few criticisms and finally concludes that the model provides an elegant and general framework for the analysis of financial markets and yields a pricing rule for securities. The state preference theory is remarkably acknowledged for providing useful addition knowledge to a financial economist’s toolkit and with a basic understanding of financial markets and prices that forms the bread and butter of financial management candidature.

Key words:State Preference, State Prices, risk neutral, valuation