Academic journal article Journal of Money, Credit & Banking

What Macroeconomic Risks Are (Not) Shared by International Investors?

Academic journal article Journal of Money, Credit & Banking

What Macroeconomic Risks Are (Not) Shared by International Investors?

Article excerpt

IF MARKETS WERE complete and if there were no transport costs, the standard economic theory predicts that we would have perfect risk sharing across national borders. In such a case, the growth rates of marginal utility would be equal across countries as international investors are able to pool all of the idiosyncratic risks they face. In reality, however, a significant part of consumption goods is non-tradables, and transport costs vary by goods and country pair. Moreover, international financial markets are far from being complete. There is no shortage of examples of market frictions such as liquidity and short-sale constraints as well as government restrictions on holdings of foreign assets. These imperfections are likely to introduce a wedge between the marginal utilities of consumption in different countries.

Most empirical studies based on aggregate consumption, including Canova and Ravn (1996), Crucini (1999), Lewis (1996), and Pakko (1998) among others, have concluded that international risk sharing is poor. In fact, correlations between consumption growth rates across countries are even weaker than correlations between output growth rates (Backus, Kehoe, and Kydland 1992). This observation supports the view that individuals have not done a good job of hedging risks across countries (Lewis 1999) and, therefore, gains from international risk sharing could be very large (Van Wincoop 1999).

The marginal utility of consumption is, however, not observable. To assess the degree of international risk sharing based on aggregate consumption, one needs to make specific assumptions about an individual's utility function. For example, under the conventional assumption of power utility function, equality of two countries' marginal utility growth rates implies equal consumption growth rates for the two countries. It is well known that such a utility function fails to reconcile the observed high equity premium with consumption data even in a single-country setting. (1) In addition, limited participation in asset markets is yet another challenge to the empirical studies of international risk sharing relationship based upon aggregate consumption. (2)

A recent study by Brandt, Cochrane, and Santa-Clara (2001) obtains a very different result about the degree of international risk sharing. Recognizing that the real exchange rate moves by the domestic-foreign marginal utility growth differential, (3) they derive the information about the marginal utility growth directly from asset returns. They find that investors face a considerable amount of risks on one hand, as measured by the large volatility of the marginal utility growth. On the other hand, they find that the correlation of the marginal utility growth rates between the two countries is very high, implying that these risks are shared surprisingly well by international investors using the existing asset markets.

Using the above asset-pricing approach of international risk sharing, this paper addresses the following empirical questions: What macroeconomic risks are shared (or not shared) by investors who participate in the international asset markets? How well do international investors insure against different kinds of idiosyncratic shocks to the economy using the existing asset markets? To this end, we incorporate the asset-market view of international risk sharing into a nonlinear structural Vector Autoregression (VAR) model that identifies various sources of macroeconomic risks, including exogenous shocks to domestic and foreign consumption growth, inflation, and monetary policies as well as exogenous shocks to asset markets. We then examine the dynamic effect of these shocks on the domestic-foreign marginal utility growth differential, which is approximated by the real depreciation of the domestic currency. If one macroeconomic risk is fully shared by international investors, then domestic and foreign marginal utility growth rates would move together in response to the shock. …

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