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A note on wealth effect under CARA utility

  • Makarov, Dmitry
  • Schornick, Astrid V.

There is a simple but overlooked way of capturing the wealth effect under CARA utility via making the absolute-risk aversion parameter wealth-dependent. We implement this approach in the asymmetric information setting of Verrecchia (1982), and compare it with the alternative approach of changing the utility function (Peress, 2004). Ours is a straightforward tractable extension of Verrecchia, while Peress has to resort to approximate methods. Importantly, our closed-form solution reveals that the relation between wealth and wealth share invested in a risky asset can be negative, while Peress's main result is that this relation is uniquely positive.

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Article provided by Elsevier in its journal Finance Research Letters.

Volume (Year): 7 (2010)
Issue (Month): 3 (September)
Pages: 170-177

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Handle: RePEc:eee:finlet:v:7:y:2010:i:3:p:170-177
Contact details of provider: Web page: http://www.elsevier.com/locate/frl

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