FIN-01-039

Standard Risk Aversion and the Demand for Risky Assets in the Presence of Background Risk

August 2001

G. Franke, Richard C. Stapleton and Marti G. Subrahmanyam

ABSTRACT

We consider the demand for state contingent claims in the presence of a zero-mean, non-hedgeable background risk. An agent is defined to be generalized risk averse if he/she reacts to an increase in background risk by choosing a demand function for contingent claims with a smaller slope. We show that the conditions for standard risk aversion: positive, declining absolute risk aversion and prudence are necessary and sufficient for generalized risk aversion. We also derive a necessary and sufficient condition for the agent's derived risk aversion to increase with a simple increase in background risk.

Classification: D52, D81, G11

G. Franke
Institution: University of Konstanz

Richard C. Stapleton
Institution: Department of Accounting and Finance, University of Strathclyde, 100, Cathedral Street, Glasgow, Scotland.
Telephone: (44) 524-381172
Fax: (44) 524-846874
Email: rcs@staplet.demon.co.uk

Marti G. Subrahmanyam
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0348
Fax: (212) 995-4233
Email: msubrahm@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~msubrahm

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