Limited Risk Sharing and International Equity Returns

Abstract

I study international risk sharing with limited stock market participation and preference heterogeneity in each country. An incomplete market model jointly generates high cross-country equity return correlation and low aggregate consumption growth correlation, while matching salient features of asset prices. The model further generates several implications that I show in the data: 1) The stockholders' cross-country consumption growth correlation is considerably higher than that of the aggregate; 2) International bond flows help agents share the labor income risk only, while the country-specific financial income fluctuations are negatively correlated with equity inflows only; 3) The stockholders' consumption risk is priced in both the home and foreign equity markets. I show that the financial integration significantly improves the stockholders' welfare without benefiting the non-stockholders.