Financial Globalization and Risk Sharing: Welfare Effects and the Optimality of Open Markets
62 Pages Posted: 17 Mar 2005
Date Written: January 2006
To study the welfare effects of investment barriers and the opening of markets to foreigners, we construct an equilibrium model of international asset pricing without agency costs that allows endogenous market participation among heterogeneous agents. Equilibrium prices and the set of participating and non-participating agents are jointly determined in equilibrium and the ability of agents to choose to participate in the market affects prices of domestic and foreign assets. We examine the welfare effects of non-participation and find that when a country moves from complete segmentation to open markets for foreigners, the cost of capital falls in the domestic market. This is consistent with empirical findings in the international asset pricing literature. Through the endogenous participation mechanism, our model is able to capture sources of economic growth. Contrary to previous models, however, we show that opening markets is not Pareto-optimal and we identify a class of domestic agents whose welfare is lower after the opening of markets. These finding have political economy interpretations and policy implications.
Keywords: International asset pricing, Capital market integration and liberalization, International risk sharing, International capital market equilibrium
JEL Classification: F3, G12, G15, G31, O16
Suggested Citation: Suggested Citation