INTERNATIONAL ECONOMIC REVIEW. ‘Vol. 35, No. 1, February 1994 RELATIVE RISK AVERSION WITH ARROW-DEBREU SECURITIES* By Dovcias W. Mirena! ‘This note considers a porfolio problem with a complete set of Arrow-Debren securities, each of which pays @ positive return in only one state. It is shown that an increase én the return to asset i in state j eauses an inerease (no change: ‘a decrease) in demand for asset iif and only if relative risk aversion evaluated in state ‘is less than (equal to: greater than) unity. Demands forall other assets change in the opposite direction. This note demonstrates a fink between the level of relative risk aversion and portfolio behavior in the context of a complete set of Arrow-Debreu securities. The result complements those of Hadar and Seo (1990), who analyzed stochastically dominating shifts of the return distribution of a stochastically independent asset in a non-Arrow-Debreu context. Theorem. Ler there he n states and n assets, such that asset i (i = Vy ++ m) pays a return r; > 0 in state i and zero otherwise. Then an investor with initial wealth Wo and with utility function U(W) defined over final wealth W, with U’ > 0 and U" < 0, will choose to increase (leave unchanged, decrease) the portfolio fraction w; placed in asset i in response to an increase in r; if and only if rela risk aversion evaluated at W= Wow)t; is less than (equal 10, greater than) one; the portfolio fractions w; (for all j # i) will change in the opposite direction from that of Wr. PRoor, Let p, be the probability of state j (7 1). Utility conditional on state j is UW) = U(Wow;r;). Denoting the Lagrange multiplier as A, the Lagrangian is (Dy L= & pUWow;r) +l — Dy ‘The first-order conditions are (2a) PaU'(Wownrn) Wore Oh bane 2b) * Manuscript teesived Apt 1992: revised December 192. "Lam grteful to Rom Balvers and two referes for helpfl comments 287 Copyright © 2001. All Rights Reseved.258 DOUGLAS W. MITCHELL Note that the second-order conditions are satisfied. Totally differentiating the first-order conditions (and denoting U' and U" evaluated at WoWwar, as Uj, and U', respectively) gives (Ba) paU', Worgdwy = —p,U%Warnwydry ~ ppUiWodry + dA, (3b) Dd dw, =6 mn Solve Ga) for dw, sum over all A letting dr, = 0 for all + i, and use (3b} to obtain dd = [rj hy + UN UD Wer] an] 8 PEA) Wo 1 Use (4) in the #th equation of (3a) solved for dw;, to obtain (5) dwyldr; = (U1) "Ur, We — Ry) xD pal (U5) we /e ping (U4) t ’ where R; = —(Wow;r UYU > 0 is the coefficient of relative risk aversion evaluated at final wealth contingent on state i. Equation (5) shows that dw;/dr; > 0, = 0, or 1. Using (4) in the jth equation of (3a) (j + #) with dr; = 0 yields (UD Ur, WoO Rips 4 UD | mm Equation (5") shows that dw,/dr,(j = i) has the sign of (R; ~ 1). QED. See Mitchell (1992) for a discussion of income and substitution effects in the case of constant relative risk aversion. West Virginia University, U.S.A REFERENCES Hapan, J. AND T. K. Se0, “The Effects of Shifts in a Return Distribution on Optimal Portfolies.” International Economic Review 34 (1990), 721-136, Mince, D. W., “An Argument for Relative Risk Aversion below Uni University, March 1992, working paper, West Vi _Copyright.©.2001 All Rights Reseyed. oe cnsnucranaranaanananannn