Risk Sharing, Finance and Institutions in International Portfolios

Abstract

We develop a standard model to show how transaction costs in international investment affect conventional tests of consumption risk sharing, both in a multilateral and a bilateral setting. We implement the tests in a novel international dataset on bilateral holdings of equity, bonds, foreign direct investment and bank loans. International consumption risk sharing increases with foreign capital holdings; this is especially true of investment in equity or bonds, but not of foreign direct investment or bank loans. In our model, this implies transaction costs are higher for FDI and international loans. The discrepancy may reflect technological differences across asset classes, but also the prospect of expropriation, perhaps most stringent for FDI or loans. We argue that expropriation risk is endogenous to both the borrower`s institutions and its openness to international markets. The detrimental impact of poor institutions is muted in open economies, where the possibility of subsequent exclusion from world markets deters expropriation of foreign capital. We show the implied non-linear effects of institutions prevail in both the cross-section of consumption risk sharing, and in observed international investment patterns.

Keywords: Risk sharing, Diversification, Portfolio Choice, Financial Integration, Cross-Border Investment

JEL Classification: F21, F30, G15