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Risk aversion with nothing to lose

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  • Pegoraro, Stefano

Abstract

In a continuous-time model, a risk-neutral decision-maker chooses the volatility of a state variable and is terminated when the variable falls below a threshold. I provide economically interpretable conditions under which the decision-maker becomes risk averse endogenously and minimizes volatility near termination, even if she faces myopic incentives to gamble for resurrection. The conditions introduce forward-looking incentives to preserve economic rents. I show these conditions are met in a wide range of apparently unrelated models, thus identifying forward-looking rents as a unifying economic mechanism behind endogenous risk aversion. I also provide conditions for the decision-maker to become risk loving endogenously.

Suggested Citation

  • Pegoraro, Stefano, 2024. "Risk aversion with nothing to lose," Journal of Economic Theory, Elsevier, vol. 221(C).
    • Handle: RePEc:eee:jetheo:v:221:y:2024:i:c:s002205312400108x
    DOI: 10.1016/j.jet.2024.105902
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