Conditional Market Co-Movements, Welfare, and Contagions: The Role of Time-Varying Risk Aversion
27 Pages Posted: 27 Sep 2003
Date Written: October 2002
In this paper, we demonstrate that time-varying investor risk aversion can generate significant state dependence in the correlation of international stock returns, despite the underlying endowment/dividend processes being i.i.d. We also find that the welfare benefits of international diversification associated with these time-varying co-movements tend to increase (rather than decrease) in states when the correlations of international stock returns are high, or when cross-market "contagions" appear most severe. In a world in which risk sharing among different countries is still imperfect, our findings imply that "contagion-like" variations in the correlation of international stock returns can arise if the benefits of international risk sharing are to be fully exploited. On this note, we conclude with a word of caution against describing international market co-movements as contagions.
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