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World Income Components: Measuring and Exploiting Risk-Sharing Opportunities

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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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.
Contact details of provider: Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
Phone: (203) 432-3702
Fax: (203) 432-6167
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Order Information: Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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