A Note on Wealth Effect under CARA Utility
15 Pages Posted: 1 Mar 2009 Last revised: 10 May 2010
Date Written: April 20, 2010
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: Suggested Citation