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Portfolio Choice with a Correlated Background Risk : Theory and Evidence

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  • Luc Arrondel
  • Hector Calvo-Pardo

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.

Suggested Citation

  • Luc Arrondel & Hector Calvo-Pardo, 2002. "Portfolio Choice with a Correlated Background Risk : Theory and Evidence," DELTA Working Papers 2002-16, DELTA (Ecole normale supérieure).
  • Handle: RePEc:del:abcdef:2002-16
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    Cited by:

    1. Luc Arrondel & André Masson & Daniel Verger, 2004. "Les comportements de l'épargnant à l'égard du risque et du temps," Économie et Statistique, Programme National Persée, vol. 374(1), pages 9-19.
    2. Luc Arrondel & André Masson & Daniel Verger, 2004. "De la théorie à une enquête méthodologique originale," Économie et Statistique, Programme National Persée, vol. 374(1), pages 21-51.
    3. Luc Arrondel & Hector Calvo Pardo & Xisco Oliver, 2007. "Temperant portfolio choice and background risk: evidence from France," Working Papers halshs-00588069, HAL.
    4. Luc Arrondel & André Masson & Daniel Verger, 2004. "Mesurer les préférences individuelles à l'égard du risque," Économie et Statistique, Programme National Persée, vol. 374(1), pages 53-85.
    5. repec:dau:papers:123456789/6826 is not listed on IDEAS

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