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Does financial integration affect real exchange rate volatility and cross-country equity market returns correlation?

  • Donadelli, Michael
  • Paradiso, Antonio

Existing empirical studies show that financial integration affects the behavior of average excess returns, cross-country equity market returns (EMR) correlations and real exchange rate (RER) volatility. We employ a recently developed two-country model with recursive preferences, frictionless and complete markets and highly correlated long-run innovations to examine whether full financial integration (i.e. full risk-sharing) affects the US-Canada EMR correlation and the US RER volatility, consistently with existing empirical findings. First, full risk-sharing gives rise to a relatively high RER volatility. Second, it induces very strong positive cross-country EMR correlations. Both quantities are higher than those observed in the US-Canada asset pricing data, and increase as the risk-sharing incentive increases. In contrast, “international consumption quantities” are weakly sensitive to changes in the level of aversion to consumption and utility risk.

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Article provided by Elsevier in its journal The North American Journal of Economics and Finance.

Volume (Year): 28 (2014)
Issue (Month): C ()
Pages: 206-220

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Handle: RePEc:eee:ecofin:v:28:y:2014:i:c:p:206-220
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/620163

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