Asset Prices and Risk Sharing in Open Economies

Abstract

This paper proposes a two-country model that features time-varying heterogeneity in conditional risk aversion across countries, endogenously arising from the interaction between external habit formation and preference home bias. The model generates high international correlation of state prices along with modest cross-country consumption growth correlation and matches the empirical disconnect between exchange rate changes and consumption growth rate differentials. The key mechanism is endogenous time variation in conditional consumption growth volatility: the conditionally less risk averse country insures the more risk averse one, offsetting cross-country heterogeneity in conditional risk aversion and leading to significant international comovement in marginal utility growth.

Keywords: Risk sharing, asset pricing, international finance, home bias, habit formation, exchange rates

JEL Classification: G12, G15, F31