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Risk Vulnerability and the Tempering Effect of Background Risk

Christian Gollier and John W. Pratt
Econometrica
Vol. 64, No. 5 (Sep., 1996), pp. 1109-1123
Published by: The Econometric Society
DOI: 10.2307/2171958
Stable URL: http://www.jstor.org/stable/2171958
Page Count: 15
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Risk Vulnerability and the Tempering Effect of Background Risk
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Abstract

We examine in this paper a new natural restriction on utility functions, namely that adding an unfair background risk to wealth makes risk-averse individuals behave in a more risk-averse way with respect to any other independent risk. This concept is called risk vulnerability. It is equivalent to the condition that an undesirable risk can never be made desirable by the presence of an independent, unfair risk. Moreover, under risk vulnerability, adding an unfair background risk reduces the demand for risky assets. Risk vulnerability generalizes the concept of properness (individually undesirable, independent risks are always jointly undesirable) introduced by Pratt and Zeckhauser (1987). It implies that the two first derivatives of the utility function are concave transformations of the original utility function. Under decreasing absolute risk aversion, a sufficient condition for risk vulnerability is local properness, i.e. r" ≥ r'r, where r is the Arrow-Pratt coefficient of absolute risk aversion.

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