On the Gains to International Trade in Risky Financial Assets

63 Pages Posted: 19 Jul 2000 Last revised: 2 Apr 2001

See all articles by Steven J. Davis

Steven J. Davis

University of Chicago; National Bureau of Economic Research (NBER)

Jeremy Nalewaik

Board of Governors of the Federal Reserve System

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Date Written: July 2000

Abstract

This paper develops and implements a framework for quantifying the gains to international trade in risky financial assets. The framework can handle may agents, many assets, incomplete markets and limited participation in asset markets. It delivers closed-form analytic solutions for consumption, portfolio allocations, asset prices and the gains to trade. We find enormous gains to trade when asset returns are calibrated to observed risk premia and all agents participate in asset markets. The gains-to-trade puzzle is closely related to, but distinct from, the equity premium puzzle. High risk aversion merely alters the form of the gains-to-trade puzzle, but limited participation in asset markets goes a long way towards addressing both puzzles. We also identify three reasons for limited international risk sharing. First, the requirement that asset markets span the space of national output shocks fails in a serious way. Second, for many countries the cost of using financial assets to hedge national output shocks greatly exceeds the benefits. Third, limited asset market participation reduces the feasible gains from international risk sharing.

Suggested Citation

Davis, Steven J. and Nalewaik, Jeremy John and Willen, Paul S., On the Gains to International Trade in Risky Financial Assets (July 2000). NBER Working Paper No. w7796. Available at SSRN: https://ssrn.com/abstract=236674

Steven J. Davis (Contact Author)

University of Chicago ( email )

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National Bureau of Economic Research (NBER)

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Jeremy John Nalewaik

Board of Governors of the Federal Reserve System ( email )

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Paul S. Willen

Federal Reserve Bank of Boston - Research Department ( email )

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Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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