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Portfolio Choice with a Correlated Background Risk : Theory and Evidence

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Author Info
Luc Arrondel
Hector Calvo-Pardo

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Abstract

We extend the static portfolio choice problem with a small background risk to the case of small partially correlated background risks. We show that respecting the theories under which risk substitution appears, except for the independence of background risk, it is perfectly rational for the individual to increase his optimal exposure to portfolio risk when risks are partially negatively correlated. Then, we test empirically the hypothesis ofrisk substitutability using INSEE data on French households. We find that households respond by increasing their stockholdings in response to the increase in future earnings uncertainty. This conclusion is in contradictionwith results obtained in other countries. So, in light of these results, our model provides an explanation to account for the lack of empirical consensus on cross-country tests of risk substitution theory that encompasses and criticises all of them.

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Paper provided by DELTA (Ecole normale supérieure) in its series DELTA Working Papers with number 2002-16.

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Date of creation: 2002
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Handle: RePEc:del:abcdef:2002-16

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  22. Luc Arrondel & André Masson, 1990. "Hypothèse du cycle de vie, diversification et composition du patrimoine: France 1986," Annales d'Economie et de Statistique, ADRES, issue 17, pages 01, Janvier-M. [Downloadable!]
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  1. Arie Kapteyn & Federica Teppa, 2009. "Subjective Measures of Risk Aversion, Fixed Costs, and Portfolio Choice," DNB Working Papers 216, Netherlands Central Bank, Research Department. [Downloadable!]
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