Limited Risk Sharing and International Equity Returns

Abstract

Limited stock market participation can potentially explain the disconnect between international asset prices and macro quantities. An incomplete markets model in which risk sharing for stockholders is high, generates highly correlated equity returns and relatively smooth exchange rates. Risk sharing for non-stockholders is limited because of their non-participation in stock markets and borrowing constraints, lowering aggregate consumption correlation and the correlation between aggregate consumption differentials and exchange rates. Further, financial integration widens the disconnect by benefiting stockholders but hurting non-stockholders. Survey data indicate that international risk sharing for stockholders is better than that for non-stockholders, lending support to the predictions.

Keywords: comovement, exchange rate, limited participation, equity return, incomplete markets

JEL Classification: F30, F41, F44, F62, F65, G11, G12, G15