First-Order (Conditional) Risk Aversion, Background Risk and Risk Diversification

20 Pages Posted: 2 Apr 2011 Last revised: 24 May 2011

See all articles by Georges Dionne

Georges Dionne

HEC Montreal - Department of Finance

Jingyuan Li

Lingnan University - Department of Finance and Insurance

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

Dionne, Georges and Li, Jingyuan, First-Order (Conditional) Risk Aversion, Background Risk and Risk Diversification (May 20, 2011). Available at SSRN: https://ssrn.com/abstract=1800135 or http://dx.doi.org/10.2139/ssrn.1800135

Georges Dionne (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-6596 (Phone)
514-340-5019 (Fax)

HOME PAGE: http://www.hec.ca/gestiondesrisques/

Jingyuan Li

Lingnan University - Department of Finance and Insurance ( email )

Castle Peak Road
Tuen Mun, New Territories
Hong Kong
China

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