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How does background risk affect portfolio choice: An analysis based on uncertain mean-variance model with background risk

Xiaoxia Huang and Tingting Yang

Journal of Banking & Finance, 2020, vol. 111, issue C

Abstract: This paper explores how background risk affects individual investment decisions under the framework of uncertainty theory. We propose an uncertain mean-variance model with background risk and give its optimal solution when the returns of stocks and background asset obey normal uncertainty distributions. On this basis, we study the characteristic of the mean-variance efficient frontier of the stock portfolio in the presence of background risk. Furthermore, we compare the proposed model with the uncertain mean-variance model without background risk and discuss the efficiency difference between the two models and further give the condition where the two models select the same stocks. Based on the comparison, we analyze how background risk affects individual portfolio choice. Finally, we give some numerical examples as illustrations.

Keywords: Uncertainty theory; Background risk; Mean-variance optimization; Portfolio selection (search for similar items in EconPapers)
JEL-codes: C61 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.jbankfin.2019.105726

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