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Increased Risk-Bearing with Background Risk

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Analyses of risk-bearing often assume that agents face only one risk when deciding how much risk to bear. Agents however usually face several risks at the same time and the interaction between risks can affect the willingness to bear any particular one of them. We consider how the introduction of uninsurable background risk affects the comparative statics predictions of distribution changes in the standard two-asset portfolio model. We show that such predictions are fairly robust, no matter what the correlation between the background risk and the risky asset's return distribution. We consider changes in the conditional distributions of the risky asset's return (holding the marginal distribution of the background risk fixed); and changes in the marginal distribution of the asset's return (holding the conditional distributions of the background risk fixed). For the first question, a version of Gollier's (1995) Central Riskiness order is sufficient and necessary to increase risk-bearing. For the second question, Monotone Likelihood Ratio improvements are sufficient and necessary.

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  • Edward Schlee & Christian Gollier, "undated". "Increased Risk-Bearing with Background Risk," Working Papers 2132848, Department of Economics, W. P. Carey School of Business, Arizona State University.
  • Handle: RePEc:asu:wpaper:2132848
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    1. D. Kira & W. T. Ziemba, 1980. "The Demand for a Risky Asset," Management Science, INFORMS, vol. 26(11), pages 1158-1165, November.
    2. Paul R. Milgrom, 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 380-391, Autumn.
    3. Peter C. Fishburn & R. Burr Porter, 1976. "Optimal Portfolios with One Safe and One Risky Asset: Effects of Changes in Rate of Return and Risk," Management Science, INFORMS, vol. 22(10), pages 1064-1073, June.
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    Cited by:

    1. Wagener, Andreas & Zenker, Juliane, 2018. "Decoupled but not neutral: The effects of stochastic transfers on investment and incomes in rural Thailand," TVSEP Working Papers wp-008, Leibniz Universitaet Hannover, Institute for Environmental Economics and World Trade, Project TVSEP.
    2. Huang, Hung-Hsi & Wang, Ching-Ping, 2013. "Portfolio selection and portfolio frontier with background risk," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 177-196.
    3. Wagener, Andreas & Zenker, Juliane, 2015. "Stochastic Transfers, Risky Investment and Incomes: Evidence from an Income Guarantee Program in Thailand," Hannover Economic Papers (HEP) dp-562, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    4. Andreas Wagener & Juliane Zenker, 2021. "Decoupled but Not Neutral: The Effects of Counter‐Cyclical Cash Transfers on Investment and Incomes in Rural Thailand†," American Journal of Agricultural Economics, John Wiley & Sons, vol. 103(5), pages 1637-1660, October.
    5. Hallegatte,Stephane & Bangalore,Mook & Jouanjean,Marie Agnes, 2016. "Higher losses and slower development in the absence of disaster risk management investments," Policy Research Working Paper Series 7632, The World Bank.

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    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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