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The Precautionary Premium and the Risk-Downside Risk Tradeoff

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Abstract

This paper shows that the precautionary premium embodies a tradeoff between risk and downside risk. It is the size of a mean-preserving spread for thish the strength of aversion to risk just offsets the strength of aversion to downside risk. Using this result, decreasing absolute prudence can be interpreted as meaning that the amount of exposure to risk (as measured by a spread) for which aversion to risk just offsets aversion to downside risk decreases as wealth increases. This happens when an increase in wealth causes a smaller percentage change in absolute downside risk aversion than in absolute risk aversion.

Suggested Citation

  • X. H. Wang & Carmen Menezes, 2002. "The Precautionary Premium and the Risk-Downside Risk Tradeoff," Working Papers 0204, Department of Economics, University of Missouri, revised 16 May 2002.
  • Handle: RePEc:umc:wpaper:0204
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    File URL: https://economics.missouri.edu/working-papers/2002/wp0204_menezes_wang.pdf
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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.
    2. Bigelow, John P & Menezes, Carmen F, 1995. "Outside Risk Aversion and the Comparative Statics of Increasing Risk in Quasi-linear Decision Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(3), pages 643-673, August.
    3. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, vol. 43(1), pages 29-77, January.
    4. Menezes, C & Geiss, C & Tressler, J, 1980. "Increasing Downside Risk," American Economic Review, American Economic Association, vol. 70(5), pages 921-932, December.
    5. Christian Gollier, 2004. "The Economics of Risk and Time," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262572249, January.
    6. Pownall, Rachel A. J. & Koedijk, Kees G., 1999. "Capturing downside risk in financial markets: the case of the Asian Crisis," Journal of International Money and Finance, Elsevier, vol. 18(6), pages 853-870, December.
    7. Garrett, Thomas A. & Sobel, Russell S., 1999. "Gamblers favor skewness, not risk: Further evidence from United States' lottery games," Economics Letters, Elsevier, vol. 63(1), pages 85-90, April.
    8. Joseph Golec & Maurry Tamarkin, 1998. "Bettors Love Skewness, Not Risk, at the Horse Track," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 205-225, February.
    9. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279-279.
    10. Campbell R. Harvey & Akhtar Siddique, 2000. "Conditional Skewness in Asset Pricing Tests," Journal of Finance, American Finance Association, vol. 55(3), pages 1263-1295, June.
    11. Menezes, Carmen F & Auten, Gerald E, 1978. "The Theory of Optimal Saving Decisions under Income Risk," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 19(1), pages 253-258, February.
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    More about this item

    Keywords

    Precautionary premium; risk; downside risk;

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General

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