Demand Risk and Diversification through Trade

I develop a theory of risk diversification through geography, where risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of sales. Both the probability of entry and trade flows to a market are increasing in the “Diversification Index”, which depends on the multilateral covariance of a country's demand with all other markets. The firms’ risk diversification behavior may imply higher welfare gains from trade than in standard trade models. Risk-augmented gravity regressions show that demand risk significantly affects trade patterns. The risk diversification channel increases welfare gains from trade by 16% relative to models with risk neutrality. The quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent Chinese boom.