Risky asset allocation and consumption rule in the presence of background risk and insurance markets

This study examines joint decisions regarding risky asset allocation and consumption rate for a representative agent in the presence of background risk and insurance markets. Contrary to the conclusion of the “mutual fund separation theorem”, we show that the optimal risky asset mix will reflect an agent’s risk attitude as long as background risk is not independent of investment risk. This result can, however, be used to solve the “riskyasset allocation puzzle”. We also unveil that optimal insurance to shift background risk is determined through establishing a hedging portfolio against investment risk and is an arrangement maintaining the balance between growth and volatility of expected consumption. Because the optimal insurance we obtain generally leads to a smoother consumption path, it may plausibly explain the “equity premium puzzle” in the financial literature.