Working Paper: NBER ID: w17872
Authors: Karen K. Lewis; Edith X. Liu
Abstract: International consumption risk sharing studies have largely ignored their models' counterfactual implications for asset returns although these returns incorporate direct market measures of risk. In this paper, we modify a canonical risk-sharing model to generate more plausible asset return behavior and then consider the effects on welfare gains. Matching the mean and variance of equity returns and the risk-free rate requires persistent consumption risk, leading to three main findings: (1) risk-sharing gains decrease as the ability to diversify persistent consumption risk decreases; (2) the international correlation of equity returns is high relative to the correlation of consumption and dividends, implying low diversification potential for persistent consumption risk; and (3) increasing persistent consumption risk reduces the gains. Taken together, our findings suggest that asset returns imply more international risk sharing than previously thought.
Keywords: International consumption risk sharing; Asset return behavior; Welfare gains; Persistent consumption risk
JEL Codes: E21; F30; F40; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| diversification capacity (D25) | welfare gains (D69) |
| persistent consumption risk (E21) | welfare gains (D69) |
| equity returns (G12) | consumption risk dynamics (E21) |
| correlation of equity returns (G12) | diversification potential (L25) |
| correlation of consumption and dividends (G35) | diversification potential (L25) |