Portfolio Choice With a Correlated Background Risk: Theory and Evidence

DELTA Working Paper No. 2002-16

47 Pages Posted: 27 Jun 2007

See all articles by Luc Arrondel

Luc Arrondel

CNRS; Paris School of Economics (PSE); Banque de France

Hector F. Calvo Pardo

University of Southampton - Economics Division

Date Written: September 2002

Abstract

In this paper, we extend the static portfolio choice problem with a small background risk to the case of small partially correlated background risks. We show that respecting the theories under which risk substitution appears, except for the independence of background risk, it is perfectly rational for the individual to increase his optimal exposure to portfolio risk when risks are partially negatively correlated. Then, we test empirically the hypothesis of risk substitutability using French households data. We found that households respond by increasing their stockholdings in response to the increase in future earnings uncertainty. This conclusion is in contradiction with results obtained in other countries.

So, in light of these results, our model provides an explanation to account for the lack of empirical consensus on cross-country tests of risk substitution theory that encompasses and criticises all of them.

Keywords: Portfolio Choice, Background Risk, Standard Risk Aversion

JEL Classification: G11, D81, C25

Suggested Citation

Arrondel, Luc and Calvo Pardo, Hector F., Portfolio Choice With a Correlated Background Risk: Theory and Evidence (September 2002). DELTA Working Paper No. 2002-16, Available at SSRN: https://ssrn.com/abstract=996444 or http://dx.doi.org/10.2139/ssrn.996444

Luc Arrondel (Contact Author)

CNRS ( email )

3, rue Michel-Ange
Paris, 75794
France

Paris School of Economics (PSE)

48 Boulevard Jourdan
Paris, 75014 75014
France

Banque de France

Paris
France

Hector F. Calvo Pardo

University of Southampton - Economics Division ( email )

University Rd.
Southampton SO17 1BJ, Hampshire SO17 1LP
United Kingdom
+442380595051 (Phone)
+442380593858 (Fax)

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