Risk Taking with Additive and Multiplicative Background Risks

We examine the effects of background risks on optimal portfolio choice. Examples of background risks include uncertain labor income, uncertainty about the terminal value of fixed assets such as housing and uncertainty about future tax liabilities. While some of these risks are additive and have been amply studied, others are multiplicative in nature and have received far less attention. The simultaneous effect of both additive and multiplicative risks has hitherto not received attention and can explain some paradoxical choice behavior. We rationalize such behavior and show how background risks might lead to seemingly U-shaped relative risk aversion for a representative investor.Derived risk aversion, Additive, multiplicative background risk

Optimal Hedging with Higher Moments

This study proposes a utility-based framework for the determination of optimal hedge ratios that can allow for the impact of higher moments on the hedging decision. The approach is applied to a set of 20 commodities that are hedged with futures contracts. We find that in sample, the performance of hedges constructed allowing for non-zero higher moments is only very slightly better than the performance of the much simpler OLS hedge ratio. When implemented out of sample, utility-based hedge ratios are usually less stable over time, and can make investors worse off for some assets compared to hedging using the traditional methods. We conclude, in common with a growing body of very recent literature, by suggesting that higher moments matter in theory but not in practice.Utility-based hedging, OLS, Non-normality, risk, commodity futures, skewness, kurtosis