First-Order (Conditional) Risk Aversion, Background Risk and Risk Diversification
20 Pages Posted: 2 Apr 2011 Last revised: 24 May 2011
Date Written: May 20, 2011
Abstract
Expected utility functions are limited to second-order (conditional) risk aversion, while non-expected utility functions can exhibit either first-order or second-order (conditional) risk aversion. We extend the concept of orders of conditional risk aversion to orders of conditional dependent risk aversion. We show that first-order conditional dependent risk aversion is consistent with the framework of the expected utility hypothesis. We relate our results to risk diversification, provide insights into their application in economic and finance examples, and discuss their relation with the stock market participation puzzle.
Keywords: Expected utility theory, first-order conditional dependent risk aversion, background risk, risk diversification, stock market participation puzzle.
JEL Classification: D81, G10.
Suggested Citation: Suggested Citation