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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. 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.
  2. Ken Miyajima, 2006. "How to Evaluate Gdp-Linked Warrants," IMF Working Papers 06/85, International Monetary Fund.
  3. 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.
  4. 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.
  5. Maria Giduskova & Borja Larrain, 2006. "International risk-taking, volatility, and consumption growth," Communities and Banking, Federal Reserve Bank of Boston.
  6. Guimarães, Bernardo, 2007. "Optimal external debt and default," CEPR Discussion Papers 6035, C.E.P.R. Discussion Papers.
  7. Desmet, Klaus & Le Breton, Michel & Ortuno-Ortin, Ignacio, 2006. "Nation Formation and Genetic Diversity," IDEI Working Papers 133, Institut d'Économie Industrielle (IDEI), Toulouse.
  8. 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.
  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. Athanasoulis, Stefano G. & Shiller, Robert J., 2002. "Defining residual risk-sharing opportunities: Pooling world income components," Research in Economics, Elsevier, vol. 56(1), pages 61-84, June.
  11. 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.

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