A Note on Wealth Effect under CARA Utility

15 Pages Posted: 1 Mar 2009 Last revised: 10 May 2010

See all articles by Dmitry Makarov

Dmitry Makarov

HSE University, International College of Economics and Finance (ICEF)

Astrid V. Schornick

Cologne Business School; INSEAD

Date Written: April 20, 2010

Abstract

There is a simple method to account for the wealth effect of investment decisions that works under CARA utility via making the absolute risk aversion parameter wealth-dependent. Focusing on the setting of Verrecchia (1982), we compare our approach with that of Peress (2004) who instead changes preferences. We demonstrate that implementing our approach leads to a straightforward, tractable analysis, while Peress has to resort to approximate methods. Importantly, our closed-form solution reveals that the relation between wealth and wealth share invested in a risky asset can be negative, while Peress's main result is that this relation is uniquely positive.

Keywords: CARA utility, wealth effect, information acquisition, asset pricing, portfolio choice

JEL Classification: D31, D51, D82, D83

Suggested Citation

Makarov, Dmitry and Schornick, Astrid V., A Note on Wealth Effect under CARA Utility (April 20, 2010). Finance Research Letters, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1350225 or http://dx.doi.org/10.2139/ssrn.1350225

Dmitry Makarov (Contact Author)

HSE University, International College of Economics and Finance (ICEF) ( email )

26 Shabolovka
Moscow
Russia

HOME PAGE: http://www.nes.ru/~dmakarov

Astrid V. Schornick

Cologne Business School ( email )

Hardefuststr. 1
Cologne, 50677
Germany

INSEAD ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
0033 160 72 4992 (Phone)
0033 160 72 4045 (Fax)

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