Evaluating international consumption risk sharing gains: An asset return view

Abstract

International consumption risk sharing studies often generate counterfactual implications for asset return behavior with potentially misleading results. We address this contradiction using data moments of consumption and asset returns to fit a canonical international consumption risk sharing framework. Introducing persistent consumption risk, we find that its correlation across countries is more important for risk sharing than that of transitory risk. To identify these risk components, we jointly exploit the comovement of equity returns and consumption. This identification implies high correlations in persistent consumption risk, suggesting a strong degree of existing risk sharing despite low consumption correlations in the data. October, 2012Abstract Multi-country consumption risk sharing studies that match the equity premium typically find very large gains from risk-sharing. However, these studies usually generate counterfactual implications for the risk-free rate and asset return variability. In this paper, we modify a canonical risk-sharing model to generate asset return behavior closer to the data and then consider the effects on welfare gains. To better fit asset return behavior, we introduce persistent consumption risk, finding that the welfare gains depend critically on the international correlation in this persistent risk. We then provide a new identification for this risk by jointly exploiting the data correlation for equity returns and for consumption. This identification implies high correlation in persistent consumption risk, suggesting a strong degree of diversification despite low correlations in transitory risk. As such, our findings show that matching equity returns can imply lower international risk sharing gains than previously thought. * This paper was previously circulated under the title "International Consumption Risk Is Shared After All: An Asset Return View." We thank seminar participants at the Aarhus University Globalization Conference, Arizona State University, Cornell University, the Dallas Federal Reserve Bank, the Econometric Society, INSEAD, Keio University, the NBER Summer Institute, the Philadelphia Federal Reserve Bank, UNC-Chapel Hill, the University of Pennsylvania, and the University of Southern California and in particular Ravi Bansal, Max Croce, Bernard Dumas, Sebnem Kalemli-Ozcan, Dana Kiku, Andreas Stathopoulos, Linda Tesar and Amir Yaron for valuable comments. Of course, any errors are ours alone.

Disaster Risk and Asset Returns: An International Perspective

“…The most direct approach to discipline the dividend process is to use dividend data itself (e.g., Bansal and Yaron (2004), Lewis and Liu (2015)). Arguably, this approach gives the best picture of the behavior of the dividend process.…”

“…24 The approach has also been used to examine risk-sharing in Cochrane (1991a), Lewis (1996), and Lewis and Liu (2015).…”

“…To do so, we ask how well the model can generate the international co-movements of asset returns and consumption that are observed in the data. In particular, a common empirical finding is that the correlations of consumption are lower than the correlations of equity returns (see Tesar (1995) and Lewis and Liu (2015)). …”

“…Since there are not enough disaster events in a given country, there are insufficient observations to detect common versus country-specific disaster events. However, Lewis and Liu (2015) propose an identification approach that is useful in this context. Given the pattern of consumption correlation such as in equation (20) along with the implied correlation patterns of asset returns in the model, we can recover the relevant patterns for identification such as λ i , λ w .…”

“…To address the inconsistencies posed by these two extreme cases, we posit a novel gener-2 See, for example, the discussion in Tesar (1995) and Lewis and Liu (2015).…”