Globalization and Risk Sharing

Abstract

The goal of this paper is to study the effects of globalization on risk sharing. We consider risk sharing with respect to both individual shocks - or domestic risk sharing - and to regional shocks - or international risk sharing. We adopt a technological view of globalization, which consists of an exogenous increase in the fraction of goods that can be traded internationally. Risk sharing takes place via financial markets where agents trade securities issued by every other agent in the world. In the absence of frictions, we show how globalization creates trade opportunities among residents of different regions of the world, thereby raising welfare. In the presence of sovereign risk, however, there emerge two crucial interactions between trade among residents within a region and trade among residents of different regions. First, the more residents within a region trade with each other, the more they can trade with residents of other regions. Second, the possibility of trade with residents of other regions sometimes leads a government to not enforce payments by its residents, destroying trade opportunities among residents within the region. The net effect on risk sharing of this process of creation and destruction of trade opportunities is ambiguous.

Keywords: globalization, risk sharing, sovereign risk, domestic markets, international markets

JEL Classification: F34, F36, G15