International Risk Sharing

The Theory

Domestic Investment and Domestic Savings

•The theory suggest that benefits of International Risk Sharing ( IRS) is that a country can invest more than its savings by borrowing abroad or earns a positive return on its excess savings by investing abroad.

•High correlation between national savings and domestic investment rates has been integrated as evidence that capital is not internationally mobile.

•Implications of this correlation for capital mobility are however unclear .

Why?

• There may be exogenous disturbance such as

1. Restrictions on labour

2. Restrictions on trade in goods markets

• Which may produce a correlation between S and I even in presence of financial markets

• This implies that relation between S and I may not shed light on international capital mobility

•Feldstein-Horioka Hypothesis

•With perfect capital mobility there should be no relation between domestic savings and domestic investment.

•Savings in each country responds to the world wide opportunities to invest while investment in that country is financed by the worldwide pool of capital.

Consumption and Risk Sharing

•Under the assumption of complete markets and Arrow-Debreu Securities, the theory suggests that marginal rate of substitution in consumption are equal over time and across the states of the world for each country so

•This means that consumption must be more correlated among countries than the output levels.

•Arrow- Debreu Securities

• Def: Arrow Debreu Securities assure a certain payoff 1+r output units in state s in next period, and zero given any other state regardless of economy.

•Given complete Markets, where people can trade Arrow- Debreu Securities corresponding to every future state of nature, such as there is no uncertainty

•Individuals in home and foreign countries equate their marginal rates of substitution between current consumption and state-contingent future consumption to the same state contingent security prices

•When two countries have identical Constant Relative Risk Aversion ( CRRA ) preferences, their share of world consumption is constant across time and therefore their share of consumption growth must be equal.

•Example: Markets more complete within than amongst countries because risk sharing higher amongst provinces.

Portfolio Diversification•There is clear incentive for agents to diversify portfolio risk in order to make their holdings B neutral and immune to large market fluctuations

•Different agents in different countries diversify their portfolios in different way and hold a different portfolio of risky assets.

References

• Obsfeld, M., Rogoff, K., Foundations of International Macroeconomics, MIT Press, ch. 5, 1996.