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The demand for a risky asset in the presence of a background risk

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Abstract

We examine the demand for a risky asset in the presence of two risks: a financial risk and a background risk which need not be financial. First, we compute the necessary and sufficient condition for a positive demand for a risky asset, showing that it depends on two terms capturing respectively the direct effect of risk premium and the dependence between the two risks. Second, we develop higher order expectation dependence concept and show that the more information about the sign of higher cross derivatives of the utility function we have, the weaker dependence conditions on distribution we achieve.

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This work is supported by National Natural Science Foundation of China (General Program) 70602012. The author would like to thank two anonymous referees for providing valuable suggestions that have led to significant improvement in this article.

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