Risk Aversion, Wealth, and Background Risk

TLDR

The study examines how absolute risk aversion relates to consumers’ endowments, attributes, background risk, and liquidity constraints. Absolute risk aversion is measured directly from household survey data by the maximum price consumers are willing to pay for a risky security. Risk aversion falls with higher endowment, contradicting CARA, has an elasticity of about 0.7, shows large unexplained heterogeneity, and rises for households facing income uncertainty or liquidity constraints.

Abstract

We use household survey data to construct a direct measure of absolute risk aversion based on the maximum price a consumer is willing to pay for a risky security. We relate this measure to consumer's endowments and attributes and to measures of background risk and liquidity constraints. We find that risk aversion is a decreasing function of the endowment—thus rejecting CARA preferences. We estimate the elasticity of risk aversion to consumption at about 0.7, below the unitary value predicted by CRRA utility. We also find that households' attributes are of little help in predicting their degree of risk aversion, which is characterized by massive unexplained heterogeneity. We show that the consumer's environment affects risk aversion. Individuals who are more likely to face income uncertainty or to become liquidity constrained exhibit a higher degree of absolute risk aversion, consistent with recent theories of attitudes toward risk in the presence of uninsurable risks.