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Risk Aversion, Wealth and Background Risk

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  • Luigi Guiso
  • Monica Paiella

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Abstract

We use household survey data to construct a direct measure of absolute risk aversion based on the maximum price a consumer is willing to pay to buy a risky security. We relate this measure to consumers' endowment and attributes and to measures of background risk and liquidity constraints. We find that risk aversion is a decreasing function of endowment - thus rejecting CARA preferences - but the elasticity to consumption is far below the unitary value predicted by the CRRA utility. We also find that households' attributes are of little help in predicting their degree of risk aversion, which is characterized by massive unexplained heterogeneity. However, the consumers' environment affects risk aversion. Individuals who are more likely to face income uncertainty or to become liquidity constrained exhibit a higher degree of absolute risk aversion, consistent with recent theories of attitudes towards risk in the presence of uninsurable risks.

Suggested Citation

  • Luigi Guiso & Monica Paiella, 2003. "Risk Aversion, Wealth and Background Risk," Temi di discussione (Economic working papers) 483, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:wptemi:td_483_03
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    More about this item

    Keywords

    heterogeneous preferences; risk tolerance; background risk; liquidity constraints;

    JEL classification:

    • D10 - Microeconomics - - Household Behavior - - - General
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General

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