First-Order (Conditional) Risk Aversion, Background Risk and Risk Diversification

Abstract

Expected utility functions are limited to second-order (conditional) risk aversion, while non-expected utility functions can exhibit either first-order or second-order (conditional) risk aversion. We extend the concept of orders of conditional risk aversion to orders of conditional dependent risk aversion. We show that first-order conditional dependent risk aversion is consistent with the framework of the expected utility hypothesis. We relate our results to risk diversification, provide insights into their application in economic and finance examples, and discuss their relation with the stock market participation puzzle.