Working Paper: NBER ID: w7796
Authors: Karen Lewis; Eric Van Wincoop; Narayana R. Kocherlakota
Abstract: This paper develops and implements a framework for quantifying the gains to international trade in risky financial assets. The framework can handle may agents, many assets, incomplete markets and limited participation in asset markets. It delivers closed-form analytic solutions for consumption, portfolio allocations, asset prices and the gains to trade. We find enormous gains to trade when asset returns are calibrated to observed risk premia and all agents participate in asset markets. The gains-to-trade puzzle is closely related to, but distinct from, the equity premium puzzle. High risk aversion merely alters the form of the gains-to-trade puzzle, but limited participation in asset markets goes a long way towards addressing both puzzles. We also identify three reasons for limited international risk sharing. First, the requirement that asset markets span the space of national output shocks fails in a serious way. Second, for many countries the cost of using financial assets to hedge national output shocks greatly exceeds the benefits. Third, limited asset market participation reduces the feasible gains from international risk sharing.
Keywords: International Trade; Risk Sharing; Financial Markets
JEL Codes: F36; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited participation in asset markets (G19) | equity premium (G12) |
| limited participation in asset markets (G19) | gains from trade (F11) |
| market completeness (G10) | extent of risk sharing (G32) |
| structure of financial markets (G10) | perceived gains from risky asset trade (G11) |
| incomplete financial markets (D52) | feasible risk-sharing gains (D61) |