Common Correlated Effects and International Risk Sharing

Existing studies of risk pooling among groups of countries are predicated upon the highly restrictive assumption that all countries have symmetric responses to aggregate shocks. We show that the conventional risk sharing test fails to isolate idiosyncratic fluctuations within countries and produces spurious results. To avoid these problems, we propose an alternative form of the risk sharing test that is robust to heterogeneous country characteristics. In our empirical example, we provide estimates using the pro- posed approach for various groupings of 158 countries.