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

  • Karen K. Lewis
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    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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    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
    Date of revision:
    Handle: RePEc:fip:fedpwp:96-6
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    1. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
    2. Svensson, Lars E O, 1988. "Trade in Risky Assets," American Economic Review, American Economic Association, vol. 78(3), pages 375-94, June.
    3. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    4. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
    5. Baxter, Marianne & Jermann, Urban J, 1997. "The International Diversification Puzzle Is Worse Than You Think," American Economic Review, American Economic Association, vol. 87(1), pages 170-80, March.
    6. 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.
    7. 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.
    8. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
    9. repec:oup:qjecon:v:105:y:1990:i:1:p:29-42 is not listed on IDEAS
    10. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
    11. Kenneth R. French & James M. Poterba, 1991. "Investor Diversification and International Equity Markets," NBER Working Papers 3609, National Bureau of Economic Research, Inc.
    12. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    13. Levy, Haim & Sarnat, Marshall, 1970. "International Diversification of Investment Portfolios," American Economic Review, American Economic Association, vol. 60(4), pages 668-75, September.
    14. Epstein, Larry G., 1988. "Risk aversion and asset prices," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 179-192, September.
    15. 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.
    16. repec:oup:qjecon:v:106:y:1991:i:2:p:327-68 is not listed on IDEAS
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