Asset Prices and Risk Sharing in Open Economies

This paper proposes a two-good, two-country general equilibrium model with external habits and home-biased preferences that addresses a number of international …nance puzzles. Speci…cally, the model reconciles the high degree of international risk sharing implied by relatively smooth exchange rates with the modest cross-country consumption growth correlations seen in the data, resolving the Brandt, Cochrane and Santa-Clara (2006) puzzle. Furthermore, the model matches the empirically observed low correlation between exchange rate changes and international consumption growth rate di¤erentials. For both e¤ects, the fundamental mechanism is time variation in consumption growth volatility, which is endogenously generated through international trade. Asset prices depend on a weighted average of the two countries’time-varying risk aversion, with the weights determined by the wealth and degree of home bias of each country. Simulation results indicate that the model is successful in matching key empirical exchange rate and international trade moments, as well as the standard asset pricing moments. JEL classi…cation: G12, G15, F31. Keywords: Risk sharing, asset pricing, international …nance, home bias, habit formation, exchange rates. University of Southern California, Marshall School of Business, Los Angeles, CA 90089. Email: [email protected]. I am thankful to Geert Bekaert and Tano Santos, my advisors at Columbia GSB, for their encouragement and support. I am also grateful to Michael Adler, Andrew Ang, Patrick Bolton, Charles Calomiris, John Cochrane, Pierre Collin-Dufresne, John Donaldson, Robert Hodrick, Gur Huberman, Michael Johannes, Martin Lettau, Lars Lochstoer, Emi Nakamura, Tomasz Piskorski, Veronica Rappoport, Paolo Siconol…, Suresh Sundaresan, Maxim Ulrich, Neng Wang and seminar participants at the Bank of Canada, Columbia GSB, Emory University (Goizueta), Georgetown University (McDonough), the Federal Reserve Board, Imperial College, the London School of Economics, London Business School, McGill University (Desautels), MIT (Sloan), NYU (Stern), the University of Piraeus, the University of Southern California (Marshall), the University of Texas Austin (McCombs) and the University of Wisconsin Madison for helpful comments.