Conditional Market Comovements, Welfare, and Contagions: The Role of Time-Varying Risk Aversion
Time-varying investor risk aversion can generate significant state dependence in the correlation of international stock returns, despite the underlying endowment/dividend processes being independent and identically distributed. The welfare benefits of international diversification associated with these time-varying comovements tend to increase (rather than decrease) when the correlations of international stock returns are high or cross-market "contagions" appear most severe. In a world where risk sharing among different countries is still imperfect, our findings imply that contagionlike variations in the correlation of international stock returns can arise if the benefits of international risk sharing are to be fully exploited.
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