The Size of Background Risk and the Theory of Risk Bearing

Abstract

We consider the demand for state contingent claims in the presence of a zero-mean, non-hedgeable background risk. An agent is defined to be generalized risk averse if he/she reacts to an increase in background risk by choosing a demand function for contingent claims with a less steep slope. We show that the conditions for standard risk aversion: positive, declining absolute risk aversion and prudence are necessary and sufficient for generalized risk aversion.