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Multiplicative Background Risk

  • Günter Franke


    (University of Konstanz, Fach D147, 78457 Konstanz, Germany)

  • Harris Schlesinger


    (Department of Economics and Finance, 200 Alston Hall, University of Alabama, Tuscaloosa, Alabama 35487-0224)

  • Richard C. Stapleton


    (University of Manchester, Crawford House, Oxford Road, Manchester, M13 9PL, England)

Although there has been much attention in recent years on the effects of additive background risks, the same is not true for its multiplicative counterpart. We consider random wealth of the multiplicative form x\~y\~, where x\~ and y\~ are statistically independent random variables. We assume that x\~ is endogenous to the economic agent but that y\~ is an exogenous and nontradable background risk that represents a type of market incompleteness. Our main focus is on how the presence of the multiplicative background risk y\~ affects risk-taking behavior for decisions on the choice of x\~. We extend the results of Gollier and Pratt (1996) to characterize conditions on preferences that lead to more cautious behavior.

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Article provided by INFORMS in its journal Management Science.

Volume (Year): 52 (2006)
Issue (Month): 1 (January)
Pages: 146-153

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Handle: RePEc:inm:ormnsc:v:52:y:2006:i:1:p:146-153
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  1. Yacine Ait-Sahalia & Andrew W. Lo, 2000. "Nonparametric Risk Management and Implied Risk Aversion," NBER Working Papers 6130, National Bureau of Economic Research, Inc.
  2. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1994. "Income Risk, Borrowing Constraints and Portfolio Choice," CEPR Discussion Papers 888, C.E.P.R. Discussion Papers.
  3. Doherty, Neil A & Schlesinger, Harris, 1983. "Optimal Insurance in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 91(6), pages 1045-54, December.
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