International Risk Sharing: Through Equity Diversification or Exchange Rate Hedging?

by Charles Engel and Akito Matsumoto

Well-known empirical puzzles in international macroeconomics concern the large divergence of equilibrium outcomes for consumption across countries from the predictions of models with full risk sharing. It is commonly believed that these risk-sharing puzzles are related to another empirical puzzle-the home-bias in equity puzzle. However, we show in a series of dynamic models that the full risk sharing equilibrium may not require much diversification of equity portfolios when there is price stickiness of the degree typically calibrated in macroeconomic models. This conclusion holds under a range of assumptions about home bias in preferences, price setting as PCP or LCP, and with or without nominal wage stickiness as long as there is some price rigidity.

The authors show that Cole and Obstfeld (1991) result that terms of trade adjustments provide for the majority of the risk-sharing benefits is only true when prices are flexible. In a log-linearized version of a two-country DSGE model with sticky prices, trade in only equities achieves complete risk sharing. For many parametrizations, households are long on home equity and short on foreign equity, so that an unexpected currency depreciation which has positive income effects under sticky prices is offset by a negative wealth shock to the portfolio. As with the results of, e.g., Devereux and Sutherland (2008), it may be interesting to see the implications of inefficient portfolio selection due to imperfect information, uncertainty, etc.

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