State Prices

State prices refer to the theoretical price of a security that pays $1 if a specific state of the world occurs, or nothing otherwise. In financial economics, state prices are used in asset pricing models to assess the value of assets under different economic conditions or states of the world. They provide insight into how much investors are willing to pay today for a payoff in a specific future scenario, helping in the valuation of contingent claims like options and insurance products.

Example

A state price might be calculated for a scenario where a stock market crash occurs, helping to price options that pay off only if such an event happens.

Key points

• Theoretical price of a security that pays $1 in a specific future scenario.

• Used in asset pricing models to value contingent claims.

• Helps in understanding how different economic states affect security pricing.

Quick Answers to Curious Questions

How are state prices used in asset pricing models?

They help assess the value of assets by pricing payoffs under specific future conditions, allowing for the valuation of contingent claims.

What role do state prices play in the valuation of options or insurance products?

They are used to determine how much an investor is willing to pay for securities that pay off in particular states, such as during economic downturns.

How do state prices differ from traditional market prices?

State prices reflect the cost of securing payoffs in specific future scenarios, while market prices represent the current value of securities under general conditions.