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Multiplicative Background Risk

Author

Listed:
  • 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)

Abstract

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.

Suggested Citation

  • Günter Franke & Harris Schlesinger & Richard C. Stapleton, 2006. "Multiplicative Background Risk," Management Science, INFORMS, vol. 52(1), pages 146-153, January.
  • Handle: RePEc:inm:ormnsc:v:52:y:2006:i:1:p:146-153
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    File URL: http://dx.doi.org/10.1287/mnsc.1050.0450
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    References listed on IDEAS

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    1. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
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    More about this item

    Keywords

    affiliated utility function; background risk; diffidence theorem; multiplicative risks; multiplicative risk vulnerability; risk vulnerability;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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