Portfolio Choice and Ambiguous Background Risk

Yusuke Osaki · Harris Schlesinger

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Decision-Making and Behavioral Economics Financial Markets and Investment Strategies Risk and Portfolio Optimization

Abstract

This paper examines how an ambiguous background risk in‡uences portfolio choice. We …rst establish conditions for ranking the expectedutility choices under each of the competing prior distributions of the background risk. We then use both the smooth ambiguity model of Klibano¤, Marinacci and Mukerji (2005) and the maxmin expected utility model of Gilboa and Schmeidler (1989) to show how ambiguity aversion lessens the demand for the risky asset. The implications of this result for the equity premium puzzle are also examined.

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References

1978Asset Prices in an Exchange Economy 1976Risk Aversion in the Small and in the Large 1989Maxmin expected utility with non-unique prior 1972Essays in the Theory of Risk-Bearing.2005A Smooth Model of Decision Making under Ambiguity 1989Precautionary Saving in the Small and in the Large 2001The Economics of Risk and Time 1996Risk Vulnerability and the Tempering Effect of Background Risk

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