Non-Market Wealth, Background Risk and Portfolio Choice

Günter Franke (), Harris Schlesinger and Richard Stapleton
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Günter Franke: University of Konstanz

No 07-11, CoFE Discussion Paper from Center of Finance and Econometrics, University of Konstanz

Abstract: We examine the effects of non-portfolio risks on optimal portfolio choice. Examples of non-portfolio risks include, among others, uncertain labor income, uncertainty about the terminal value of fixed assets such as housing and uncertainty about future tax liabilities . In particular, while some of these risks are added to portfolio value and have been amply studied, others are multiplicative in nature and have received far less attention. Moreover, the combined effects of multiple risks lead to some seemingly paradoxical choice behavior. We rationalize such behavior and we show how non-portfolio risks might lead to seemingly U-shaped relative risk aversion for a representative investor, as found empirically by Ait-Sahilia and Lo (2000) and Jackwerth (2000).

Keywords: Portfolio choice; Derived relative risk aversion; Additive background risk; Multiplicative background risk (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-rmg and nep-upt
Date: Written 2007-07-26

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