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International Risk Sharing is Better Than You Think (or Exchange Rates are Much Too Smooth)

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  • Michael W. Brandt
  • John H. Cochrane
  • Pedro Santa-Clara

Abstract

Exchange rates depreciate by the difference between the domestic and foreign marginal utility growths. Exchange rates vary a lot , as much as 10% per year. However, equity premia imply that marginal utility growths vary much more, by at least 50% per year. This means that marginal utility growths must be highly correlated across countries -- international risk sharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do -- exchange rates are much too smooth. We calculate an index of international risk sharing that formalizes this intuition in the context of both complete and incomplete capital markets. Our results suggest that risk sharing is indeed very high across several pairs of countries.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8404.

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Date of creation: Jul 2001
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Publication status: published as Brandt, Michael W., John H. Cochrane and Pedro Santa-Clara. "International Risk Sharing Is Better Than You Think, Or Exchange Rates Are Too Smooth," Journal of Monetary Economics, 2006, v53(4,May), 671-698.
Handle: RePEc:nbr:nberwo:8404

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Cited by:
  1. Roberto Rigobon & Anna Pavlova, 2004. "Asset Prices and Exchange Rates," Econometric Society 2004 North American Winter Meetings 579, Econometric Society.
  2. Pierre Perron & Tatsuma Wada, 2005. "Let’s Take a Break: Trends and Cycles in US Real GDP," Boston University - Department of Economics - Working Papers Series wp2009-006, Boston University - Department of Economics, revised Feb 2009.
  3. Narayana R. Kocherlakota & Luigi Pistaferri, 2007. "Household Heterogeneity and Real Exchange Rates," Economic Journal, Royal Economic Society, vol. 117(519), pages C1-C25, 03.
  4. Hanno Lustig, 2005. "Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution (joint with Adrien Verdelhan, BU, forthcoming in Papers and Proceedings JEEA)," UCLA Economics Online Papers 368, UCLA Department of Economics.
  5. Ravi Bansal, 2007. "Long-Run Risks and Financial Markets," NBER Working Papers 13196, National Bureau of Economic Research, Inc.
  6. Roche, M.J. & Moore. M.J., 2002. "Volatile and persistent real exchange rates without the contrivance of sticky prices," Economics, Finance and Accounting Department Working Paper Series n1160402, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  7. Timothy K. Chue, 2004. "The Spirit of Capitalism and International Risk Sharing," Econometric Society 2004 Far Eastern Meetings 589, Econometric Society.
  8. Cappiello, Lorenzo & De Santis, Roberto A., 2005. "Explaining exchange rate dynamics: the uncovered equity return parity condition," Working Paper Series 0529, European Central Bank.
  9. Shu Wu, 2007. "Interest Rate Risk and the Forward Premium Anomaly in Foreign Exchange Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 423-442, 03.
  10. Brandt, Michael W. & Santa-Clara, Pedro, 2002. "Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets," Journal of Financial Economics, Elsevier, vol. 63(2), pages 161-210, February.

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