Risky Choices and Correlated Background Risk

The analysis of a risky project should take into account not only uncertainties about the return from that project (“project risk”), but also uncertainties associated with other ongoing projects and with exogenous factors that can impact final wealth (“background risk”). The presence of background risk can change the optimal course of action with respect to a project, and ignoring such risk might lead to a poor decision. Most work on background risk assumes that project risk and background risk are independent and are additive in their impact on wealth. However, independence is often unrealistic, and background risk operates in a multiplicative manner in many situations. We relax the independence assumption and consider a model with both additive and multiplicative background risk. The optimal decisions in the correlated setting can be very different than those that would appear optimal if the correlation were ignored. The impact of correlation differs in the additive and multiplicative cases, with positive correlation being beneficial in some cases and negative correlation in others. The analytical and numerical results indicate that in analyzing decision-making problems, it is very important to understand the direction and degree of dependence between project risk and background risks.