On the (Mis)Use of Wealth as a Proxy for Risk Aversion

Abstract

Tests of risk sharing in the contracting literature often rely on wealth as a proxy for risk aversion. The intuition behind these tests is that since contract choice is monotonic in the coefficients of risk aversion, which are themselves assumed monotonic in wealth, the effect of a change in wealth on contract choice is clearly identified. We show that tests of risk sharing relying on wealth as a proxy for risk aversion are only identified insofar as the econometrician is willing to assume that (i) the principal is risk-neutral or her preferences exhibit CARA; and (ii) the agent is risk-neutral.

Keywords: Contract theory, principal-agent models, risk sharing, empirical tests, risk aversion

JEL Classification: C12, D86, G32, Q19