Risk aversion with nothing to lose

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.

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