RISK VULNERABILITY AND THE TEMPERING EFFECT OF BACKGROUND RISK

We examine in this paper a new natural restriction on utility function s, namely that adding an unfair background risk to wealth makes risk-a verse individuals behave in a more risk-averse way with respect to any other independent risk. This concept is called risk vulnerability. It is equivalent to the condition that an undesirable risk can never be made desirable by the presence of an independent, unfair risk. Moreove r, under risk vulnerability, adding an unfair background risk reduces the demand for risky assets. Risk vulnerability generalizes the concep t of properness (individually undesirable, independent risks are alway s jointly undesirable) introduced by Pratt and Zeckhauser (1987). It i mplies that the two first derivatives of the utility function are conc ave transformations of the original utility function. Under decreasing absolute risk aversion, a sufficient condition for risk vulnerability is local properness, i.e. r '' r'r, where r is the Arrow-Pratt coeffi cient of absolute risk aversion.