Can Fundamentals Explain Cross-Country Correlations of Asset Returns

In the last few years, the empirical literature has documented that existing correlations between national returns are higher than correlations between the national growth rates of fundamental variables. In this paper we study the ability of intertemporal asset pricing models to explain cross-country correlations of national returns. When capital markets are assumed to be perfectly integrated, an intertemporal general equilibrium model is able to explain the obtained covariability of domestic asset returns but at the expense of generating too little variability in those returns. Results improve considerably if a partial, rather than a general equilibrium version of the fully integrated capital market model is employed and the analysis is continued to the last two decades in which capital flows are more liberalized. Then, both domestic variability and cross-country covariability of returns can be explained by using single international discount-factor of domestic aggregate dividends.