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

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.