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Effects of background risks on cautiousness with an application to a portfolio choice problem

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  • Hara, Chiaki
  • Huang, James
  • Kuzmics, Christoph

Abstract

We provide necessary and sufficient conditions on an individual's expected utility function under which any zero-mean idiosyncratic risk increases cautiousness (the derivative of the reciprocal of the absolute risk aversion), which is the key determinant for this individual's demand for options and portfolio insurance.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 146 (2011)
Issue (Month): 1 (January)
Pages: 346-358

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Handle: RePEc:eee:jetheo:v:146:y:2011:i:1:p:346-358

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Web page: http://www.elsevier.com/locate/inca/622869

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Keywords: Risk aversion Risk tolerance Cautiousness Portfolio insurance Idiosyncratic risks Background risks Incomplete markets;

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  1. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  2. Franke, Gunter & Stapleton, Richard C. & Subrahmanyam, Marti G., 1998. "Who Buys and Who Sells Options: The Role of Options in an Economy with Background Risk," Journal of Economic Theory, Elsevier, vol. 82(1), pages 89-109, September.
  3. Brennan, M.J. & Solanki, R., 1981. "Optimal Portfolio Insurance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(03), pages 279-300, September.
  4. Leland, Hayne E, 1980. " Who Should Buy Portfolio Insurance?," Journal of Finance, American Finance Association, vol. 35(2), pages 581-94, May.
  5. Miles S. Kimball, 1991. "Precautionary Motives for Holding Assets," NBER Working Papers 3586, National Bureau of Economic Research, Inc.
  6. Hara, C. & Christoph Kuzmics, 2004. "Representative Consumer's Risk Aversion and Efficient Risk-Sharing Rules," Cambridge Working Papers in Economics 0452, Faculty of Economics, University of Cambridge.
  7. Marti G. Subrahmanyam & Günter Franke & Richard C. Stapleton, 1998. "Who Buys and Who Sells Options: The Role and Pricing of Options in an Economy with Background Risk," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-063, New York University, Leonard N. Stern School of Business-.
  8. Kihlstrom, Richard E & Romer, David & Williams, Steve, 1981. "Risk Aversion with Random Initial Wealth," Econometrica, Econometric Society, vol. 49(4), pages 911-20, June.
  9. Gollier, Christian & Pratt, John W, 1996. "Risk Vulnerability and the Tempering Effect of Background Risk," Econometrica, Econometric Society, vol. 64(5), pages 1109-23, September.
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