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Consumption, stock returns, and the gains from international risk-sharing

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  • Karen K. Lewis
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    Abstract

    Standard theoretical models predict that domestic residents should diversify their portfolios into foreign assets much more than observed in practice. Whether this lack of diversification is important depends on the potential gains from risk-sharing. General equilibrium models and consumption data tend to find that the costs are small, typically less than 0.5% of permanent consumption. On the other hand, stock returns imply gains that are several hundred times larger. In this paper, the author examines the reasons for these differences and finds that the primary differences are due to (a) the much higher variability of stocks, and/or (b) the higher degree of risk aversion required to reconcile an international equity premium. Furthermore, contrary to conventional wisdom, treating stock returns as exogenous does not necessarily imply greater gains.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 96-6.

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    Date of creation: 1996
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    Handle: RePEc:fip:fedpwp:96-6

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    Keywords: Consumption (Economics) ; Investments ; Stock market;

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    1. Svensson, Lars E O, 1988. "Trade in Risky Assets," American Economic Review, American Economic Association, vol. 78(3), pages 375-94, June.
    2. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
    3. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
    4. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
    5. Marianne Baxter & Urban J. Jermann, 1995. "The International Diversification Puzzle is Worse Than You Think," NBER Working Papers 5019, National Bureau of Economic Research, Inc.
    6. Shmuel Kandel & Robert F. Stambaugh, 1991. "Asset Returns and Intertemporal Preferences," NBER Working Papers 3633, National Bureau of Economic Research, Inc.
    7. Clarida, Richard H, 1990. "International Lending and Borrowing in a Stochastic, Stationary Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(3), pages 543-58, August.
    8. Obstfeld, Maurice, 1994. "Evaluating risky consumption paths: The role of intertemporal substitutability," European Economic Review, Elsevier, vol. 38(7), pages 1471-1486, August.
    9. French, Kenneth R & Poterba, James M, 1991. "Investor Diversification and International Equity Markets," American Economic Review, American Economic Association, vol. 81(2), pages 222-26, May.
    10. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-75, August.
    11. Summers, Robert & Heston, Alan, 1991. "The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950-1988," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 327-68, May.
    12. Stockman, Alan C & Tesar, Linda L, 1995. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," American Economic Review, American Economic Association, vol. 85(1), pages 168-85, March.
    13. Epstein, Larry G., 1988. "Risk aversion and asset prices," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 179-192, September.
    14. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    15. Levy, Haim & Sarnat, Marshall, 1970. "International Diversification of Investment Portfolios," American Economic Review, American Economic Association, vol. 60(4), pages 668-75, September.
    16. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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    Cited by:
    1. Patrick F. Rowland & Linda L. Tesar, 2004. "Multinationals and the Gains from International Diversification," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(4), pages 789-826, October.
    2. Stéphane Auray & Aurélien Eyquem & Jean-Christophe Poutineau, 2008. "The Welfare Gains of Trade Integration in the European Monetary Union," Cahiers de recherche 08-10, Departement d'Economique de la Faculte d'administration à l'Universite de Sherbrooke.
    3. Mirakhor, Abbas, 2007. "Islamic Finance and Globalization: A Convergence?," MPRA Paper 56026, University Library of Munich, Germany.
    4. Jean Imbs & Paolo Mauro, 2007. "Pooling Risk Among Countries," IMF Working Papers 07/132, International Monetary Fund.
    5. Stefano G. Athanasoulis & Robert J. Shiller, 2001. "World Income Components: Measuring and Exploiting Risk-Sharing Opportunities," American Economic Review, American Economic Association, vol. 91(4), pages 1031-1054, September.

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