Multiplicative Background Risk
Günter Franke, Harris Schlesinger, Richard C. Stapleton
Management Science · 2006 · Volume 52 · Issue 1
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 x̃ỹ , where x̃ and ỹ are statistically independent random variables. We assume that x̃ is endogenous to the economic agent but that ỹ 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 ỹ affects risk-taking behavior for decisions on the choice of x̃ . We extend the results of Gollier and Pratt (1996) to characterize conditions on preferences that lead to more cautious behavior.
Keywords
affiliated utility function, background risk, diffidence theorem, multiplicative risks, multiplicative risk vulnerability, risk vulnerability
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