What are state prices?
A state price security is a contract that agrees to pay one unit of a commodity or currency if a particular state is reached but otherwise pays zero. The price of this type of security is called the state price.
Where have you heard about state prices?
State prices get their origins from the Arrow-Debreu model. This suggests that under certain economic states there must be a set of prices that prove the existence of a competitive economic equilibrium.
What you need to know about state prices.
Let's take ice lollies as an example. They can be split into sales when the weather is good and sales when the weather is bad. Therefore, good-weather and bad-weather ice lollies tomorrow can be traded separately.
For example, a commodity contract pays £1 if tomorrow's weather is good and nothing if the weather is bad.
State prices are helpful for understanding the analysis of derivatives. By using the Arrow-Debreu model, you may be able to better understand how pricing and hedging are related to derivatives contracts.
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