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Time-Varying Risk Premia and Capital Flows to Developing Countries

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  • Ina Simonovska

    (University of California, Davis)

  • Espen Henriksen

    (UC Davis)

Abstract

One of the most well-known puzzles in international economics is the Lucas paradox: Why doesn't capital flow from rich to poor countries? Given the low capital-output ratios in developing countries, the difference in unconditional expected returns from investing there rather than in developed markets is too high to compensate for risk alone. Hence, the Lucas paradox shares key features with well-known asset-pricing puzzles. In this paper, we study whether pricing kernels, as in Bansal and Yaron (2004), that can rationalize the equity-premium puzzle can also account for the Lucas paradox. Bansal and Yaron (2004) show that time-varying uncertainty associated with long-run trend growth shapes asset valuations. In addition, Aguiar and Gopinath (2007) find that shocks to trend growth are the primary source of fluctuations in emerging markets. Finally, Borri and Verdelhan (2012) argue that there exists a strong positive correlation between the macroeconomic conditions in developing and developed countries. The last two facts suggest that time-varying risk premia are potentially a key ingredient necessary to account for the lack of capital flows to developing countries.

Suggested Citation

  • Ina Simonovska & Espen Henriksen, 2013. "Time-Varying Risk Premia and Capital Flows to Developing Countries," 2013 Meeting Papers 1258, Society for Economic Dynamics.
  • Handle: RePEc:red:sed013:1258
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    References listed on IDEAS

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    1. Adrien Verdelhan & Nicola Borri, 2010. "Sovereign Risk Premia," 2010 Meeting Papers 1122, Society for Economic Dynamics.
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    3. Mariano M. Croce & Marin Lettau & Sydney Ludvigson, 2006. "Investor Information, Long-Run Risk, and the Duration fo Risky Assets," 2006 Meeting Papers 628, Society for Economic Dynamics.
    4. Ravi Bansal & Dana Kiku & Amir Yaron, 2009. "An Empirical Evaluation of the Long-Run Risks Model for Asset Prices," NBER Working Papers 15504, National Bureau of Economic Research, Inc.
    5. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153-181.
    6. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-969, July.
    7. Rabanal, Pau & Rubio-Ramírez, Juan F. & Tuesta, Vicente, 2011. "Cointegrated TFP processes and international business cycles," Journal of Monetary Economics, Elsevier, vol. 58(2), pages 156-171, March.
    8. Rui Castro & Gian Luca Clementi & Glenn MacDonald, 2004. "Investor Protection, Optimal Incentives, and Economic Growth," The Quarterly Journal of Economics, Oxford University Press, vol. 119(3), pages 1131-1175.
    9. Emi Nakamura & Dmitriy Sergeyev & Jón Steinsson, 2017. "Growth-Rate and Uncertainty Shocks in Consumption: Cross-Country Evidence," American Economic Journal: Macroeconomics, American Economic Association, vol. 9(1), pages 1-39, January.
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