high level of international risk sharing when the productivity growth contains long run risk

Chang, Yanqin (2007): high level of international risk sharing when the productivity growth contains long run risk.

Abstract

This theoretical paper investigates international risk sharing and its implications for equity home bias. A general equilibrium model, featuring two closed economies with nontrivial production sectors, is developed. Moreover, productivity contains a small but persistent highly correlated long run risk that becomes the major determinant of the intertemporal marginal rate of substitution (IMRS) in a model with the recursive preferences. Despite adopting the model of closed economies and autarkic asset holdings—a scenario leading to the lowest level of international risk sharing under the same conditions—our model is still able to generate international risk sharing indexes always over 96% for a broad range of parameter values, excepting two cases: where the elasticity of intertemporal substitution (EIS) is the reciprocal of the relative risk aversion (RRA); and where EIS is around 0.7. In those cases, the risk sharing index drops sharply to about 30%. This result sheds light on why the benchmark model, featuring a power utility whereby EIS is the reciprocal of RRA, generates international risk sharing as low as 30%. However, when EIS takes these values, our model’s results cannot be reconciled with asset market data-model yields low volatility of the logarithms of IMRS, even lower than Hansen-Jagannathan lower bound. The implication is that the low proportion of foreign assets in a domestic agent’s portfolio, a phenomenon observed in the data, might not be a puzzle or a departure from the agent's optimality condition. After all, risk has already been well shared internationally due to the high correlations across countries of the long run productivity shocks. Hence, there is not much incentive left for an agent to hold foreign assets in her portfolio to further share the risk internationally. Therefore, equity home bias might not be a puzzle as claimed by the benchmark model, in the sense that it can be adequately reconciled with our theoretical result

• Item Type: MPRA Paper
• Language: English
• Keywords: International risk sharing; production; long run risk; recursive preferences
• Subjects: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; F - International Economics > F3 - International Finance > F30 - General

References

Attanasio, O. P., Weber, G., 1989, Intertemporal substitution, risk aversion and the euler equation for consumption, Economic Journal, Supplement: Conference Papers, 99, 59-73. Attanasio, O. P., Vissing-Jorgensen, A., 2003, Stock market participation, intertemporal substitution and risk aversion, American Economic Review Paper and Proceedings, 93(2), 383-391. Backus, D. K., Smith, G. W., 1993, Consumption and real exchange rates in dynamic economies with non-traded goods, Journal of International Economics, 35, 297-316. Backus, D. K., Kehoe, P. J., Kydland, F. E., 1992, International real business cycles, Journal of Political Economy, 100(4), 745-775. Backus, D. K., Kehoe, P. J., Kydland, F. E., 1995, International business cycles: theory vs. evidence, In T.F. Cooley, eds, Frontiers of business cycle research, Princeton, Princeton University Press. Backus, D. K., Foresi, S., Telmer, C. I., 2001, Affine term structure models and the forward premium anomaly, Journal of Finance, 56(1), 279-304. Bansal, R., Yaron, A., 2004, Risks for the long run: a potential resolution of asset pricing puzzles, Journal of Finance, 59(4), 1481-1509. Bansal, R., Shaliastovich, I., 2006, Long-run risks explanation of forward premium puzzle, Mimeo, Duke University. Boldrin, M., Christiano, L. J., Fisher, J., 2001, Habit persistence, asset returns, and the business cycle, American Economic Review, 91, 149-166. Brandt, M. W., Cochrane, J. H., Santa-Clara, P., 2006, International risk sharing is better than you think, or exchange rates are too smooth, Journal of Monetary Economics, 53, 671-698. Campbell, J. Y., 1994, Inspecting the mechanism: an analytical approach to the stochastic growth model, Journal of Monetary Economics, 33, 463-506. Campbell, J. Y., 1999, Asset prices, consumption, and the business cycle, In J. B. Taylor and M. Woodford, eds, Handbook of Macroeconomics, Vol. 1, North-Holland, Amsterdam, 1231-1303. Campbell, J. Y., 2003, Consumption-based asset pricing, In G. Constantinides, M. Harris and R. Stulz, eds, Handbook of the economics of finance, Vol. IB, North-Holland, Amsterdam, 803-887. Colacito, R., Croce, M. M., 2005, Risks for the long run and the real exchange rate, Mimeo, New York University. Croce, M. M., 2006, Welfare costs and long-run consumption risk in a production economy, Mimeo, New York University. Eberly, J., 1997, International evidence on investment and fundamentals, European Economic Review, 41(6), 1055-1078. Epstein, L. G., Zin, S. E., 1989, Substitution, risk aversion, and the temporal behavior of asset returns: a theoretical framework, Econometrica, 57, 937-968. Epstein, L. G., Zin, S. E., 1991, Substitution, risk aversion, and the temporal behavior of asset returns: An empirical investigation, Journal of Political Economy, 99, 263-286. Fama, E. F., 1984, Forward and spot exchange rates, Journal of Monetary Economics, 14, 319-338. Favero, C., 2005, Consumption, wealth, the elasticity of intertemporal substitution and long-run stock market returns, University Bocconi, Italy. Guvenen, F., 2006, Reconciling conflicting evidence on the elasticity of intertemporal substitution: a macroeconomic perspective, Journal of Monetary Economics, 53, 1451-1472. Hall, R., 1988, Intertemporal substitution in consumption, Journal of Political Economy, 96, 339-357. Hansen, L. P., Singleton, K. J., 1983, Stochastic consumption, risk aversion, and the temporal behavior of asset returns, Journal of Political Economy, 91, 249-268. Hansen, L. P., Jagannathan, R., 1991, Implications of security market data for models of dynamic economies, Journal of Political Economy, 99, 225-262. Kydland, F. E., Prescott, E. C., 1982, Time to build and aggregate fluctuations, Econometrica, 50 (6), 1345-1370. Lustig, H., Van Nieuwerburgh, S., 2005, The returns on human capital: good news on Wall street is bad news on main street, NBER working paper, No. 11564. Mehra, R., Prescott, E. C., 1985, The equity premium: A puzzle, Journal of Monetary Economics, 15, 145-161. Tallarini, T. D. Jr., 2000, Risk-sensitive real business cycles, Journal of Monetary Economics, 45, 507-532. Uhlig, H., 1999, A toolkit for analyzing nonlinear dynamic stochastic models easily, In R. Marimon and A Scott, eds, Computational methods for the study of dynamic economics, Oxford, Oxford Univeristy Press. Vissing-Jorgensen, A., 2002, Limited asset market participation and the elasticity of intertemporal substitution in consumption, Journal of Political Economy, 110, 825-853. Weil, P., 1989, The equity premium puzzle and the risk-free rate puzzle, Journal of Monetary Economics, 24, 401-421.