A note on wealth effect under CARA utility |
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Authors: | Dmitry Makarov Astrid V. Schornick |
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Affiliation: | 1. University of St Andrews, School of Economics and Finance, St Andrews, KY16 9AL, UK;2. CEPR, University of St Andrews, St Andrews, KY16 9AL, UK;2. CEPR, London, United Kingdom;3. CFS, Goethe University Frankfurt, Frankfurt, Germany;4. NBER, Cambridge, MA, United States;5. Netspar, Tilburg, The Netherlands |
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Abstract: | There is a simple but overlooked way of capturing the wealth effect under CARA utility via making the absolute-risk aversion parameter wealth-dependent. We implement this approach in the asymmetric information setting of Verrecchia (1982), and compare it with the alternative approach of changing the utility function (Peress, 2004). Ours is a straightforward tractable extension of Verrecchia, 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. |
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