Chapter

Risk Aversion, Background Risk, and the Pricing Kernel

Ser-Huang Poon and Richard Stapleton

in Asset Pricing in Discrete Time

Published in print January 2005 | ISBN: 9780199271443
Published online July 2005 | e-ISBN: 9780191602559 | DOI: http://dx.doi.org/10.1093/0199271445.003.0002
Risk Aversion, Background Risk, and the Pricing Kernel

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‘Risk Aversion, background Risk, and the Pricing Kernel’ looks in more detail at utility functions and their effect on the shape of the pricing kernel. The authors discuss the meaning of risk aversion and, in particular, ‘relative risk aversion’ and show that if relative risk aversion is constant at different levels of wealth, then the pricing kernel exhibits constant elasticity. They then show that the introduction of ‘background risk’, that is, non-hedgeable risks, causes the pricing kernel to exhibit declining elasticity. This effect on the pricing kernel is particularly significant for the pricing of options.

Keywords: background risk; constant elasticity; declining elasticity; relative risk aversion; utility

Chapter.  6259 words.  Illustrated.

Subjects: Financial Markets

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