DP2728 Risk Aversion, Wealth and Background Risk

Author(s): Luigi Guiso , Monica Paiella

Publication Date: March 2001

Keyword(s): Background Risk , Heterogeneous Preferences , Risk Aversion , Prudence

JEL(s): D10 , D80

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP2728.asp

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 to enter a lottery. We relate this measure to consumers' endowment and attributes and to measures of background risk. We find that risk aversion is a decreasing function of endowment - thus rejecting CARA preferences – but that the elasticity to consumption is far 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. The consumers' environment, however, affects risk aversion. Individuals who are more likely to face income uncertainty exhibit a higher degree of absolute risk aversion, consistent with recent theories of attitudes towards risk in the presence of uninsurable risks. We also find that risk attitudes have considerable predictive power over several household decisions, including occupation and portfolio choice, moving decisions and health status.