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World Income Components: Measuring and Exploiting Risk-Sharing Opportunities

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Abstract

We provide a method for decomposing the variance of changes in incomes in the world into components, world income components (WICs), in such a way as to indicate the most important risk-sharing opportunities among people of the world. We develop a constant absolute risk premium model, an intertemporal general equilibrium model of the world that facilitates consideration of optimal contract design. We show that for a contract designer maximizing a social welfare function, the optimal risk-management contracts maximize the equilibrium world real interest rate. That is the contract designer achieves the risk-optimal interest rate. We show that these WIC securities are defined in terms of eigenvectors of a transformed variance matrix of income changes. The method is applied with a variance matrix estimated using Penn World Table data on the G-7 countries, 1950-92.

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File URL: http://cowles.econ.yale.edu/P/cd/d12a/d1239.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1239.

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Length: 43 pages
Date of creation: Oct 1999
Date of revision:
Publication status: Published in The American Economic Review (2001), 91(4): 1031-1054
Handle: RePEc:cwl:cwldpp:1239

Note: CFP 1029.
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Keywords: Constant Absolute Risk Premium; risk-optimal interest rate; three-level income model; WIC securities; contract design; macro markets; hedging;

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Citations

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Cited by:
  1. David Kim & Jeffrey Sheen, 2007. "Consumption Risk-Sharing within Australia and with New Zealand," The Economic Record, The Economic Society of Australia, vol. 83(260), pages 46-59, 03.
  2. Viral V. Acharya & Alberto Bisin, 2005. "Optimal Financial-Market Integration and Security Design," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2397-2434, November.
  3. Bernardo Guimaraes, 2008. "Optimal external debt and default," LSE Research Online Documents on Economics 3604, London School of Economics and Political Science, LSE Library.
  4. Stephane Pallage & Michel A. Robe, 2002. "The States vs. the states: On the Welfare Cost of Business Cycles in the U.S," Cahiers de recherche du Département des sciences économiques, UQAM 20-17, Université du Québec à Montréal, Département des sciences économiques, revised Oct 2002.
  5. DESMET, Klaus & LE BRETON, Michel & ORTUNO-ORTIN, Ignacio & WEBER, Shlomo, 2006. "Nation formation and genetic diversity," CORE Discussion Papers 2006095, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  6. Stefano Athanasoulis & Robert J. Shiller, 2001. "Defining Residual Risk-Sharing Opportunities: Pooling World Income Components," Yale School of Management Working Papers ysm209, Yale School of Management.
  7. Mario Sarcinelli, 2003. "Crisi economiche e mercati finanziari:  di aiuto un nuovo ordine finanziario?," Moneta e Credito, Economia civile, vol. 56(224), pages 387-422.
  8. Mark J. Kamstra & Robert J. Shiller, 2009. "The Case for Trills: Giving the People and Their Pension Funds a Stake in the Wealth of the Nation," Cowles Foundation Discussion Papers 1717, Cowles Foundation for Research in Economics, Yale University.
  9. Robert J. Shiller, 2003. "Social Security and Individual Accounts as Elements of Overall Risk-Sharing," American Economic Review, American Economic Association, vol. 93(2), pages 343-347, May.
  10. Ken Miyajima, 2006. "How to Evaluate Gdp-Linked Warrants," IMF Working Papers 06/85, International Monetary Fund.
  11. Maria Giduskova & Borja Larrain, 2006. "International risk-taking, volatility, and consumption growth," Communities and Banking, Federal Reserve Bank of Boston.

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