An Analysis of Portfolio Selection with Background Risk

This paper investigates the impact of background risk on an investor's portfolio choice in a mean-variance framework, and analyzes the properties of efficient portfolios as well as the investor's hedging behaviour in the presence of background risk. Our model implies that the efficient portfolio with background risk can be separated into two independent components: the traditional mean-variance efficient portfolio, and a self-financing component constructed to hedge against background risk. Our analysis also shows that the presence of background risk shifts the efficient frontier of financial assets to the right with no changes in its shape. Moreover, both the composition of the hedge portfolio and the location of the efficient frontier are greatly affected by a number of background risk factors, including the proportion of background assets in total wealth and the correlation between background risk and financial risk.

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