Abstract:

In their seminal works, Arrow (1965) and Pratt (1964) defined two aspects of risk aversion: absolute risk aversion and relative risk aversion. Based on their definitions, we define two aspects of risk: absolute risk and relative risk. We consider situations in which, by making an investment, an agent exchanges a certain amount of wealth w by a random distributed level of wealth W. In such situations, we define absolute risk as the riskiness of a gamble that is distributed as W-w, and relative risk as the riskiness of a security that is distributed as W/w. We measure absolute risk by the Aumann and Serrano (2008) index of riskiness and relative risk by an equivalent index that we develop in this paper. The two concepts of risk do not necessarily agree on which one of two investments is riskier, and hence they capture two different aspects of risk.

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