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Background Risk and Trading in a Full-Information Rational Expectations Economy

33 Pages Posted: 8 Sep 2009  

Richard Stapleton

University of Manchester - Division of Accounting and Finance

Marti G. Subrahmanyam

New York University - Stern School of Business

Qi Zeng

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Date Written: January 2012

Abstract

In this paper, we assume that investors have the same information, but trade due to the evolution of their non-market wealth. In our formulation, investors rebalance their portfolios in response to changes in their expected non-market wealth, and hence trade. We assume an incomplete market in which risky non-market wealth is non-hedgeable and independent of market risk, and thus represents an additive background risk. Investors who experience positive shocks to their expected wealth buy more stocks from those who experience less positive shocks. The extent of trading depends on the heterogeneity of the shocks to the expected background risk across the agents. The demands of the two agents are convex or concave in the state of the economy, which justifies trading in the aggregate assets and contingent claims.

Suggested Citation

Stapleton, Richard and Subrahmanyam, Marti G. and Zeng, Qi, Background Risk and Trading in a Full-Information Rational Expectations Economy (January 2012). NYU Working Paper No. 2451/31419. Available at SSRN: https://ssrn.com/abstract=1469127

Richard Stapleton

University of Manchester - Division of Accounting and Finance ( email )

Crawford House
Oxford Road
Manchester M13 9PL
United Kingdom

HOME PAGE: http://rstapleton.com/

Marti Subrahmanyam (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

Qi Zeng

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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