The Role of Multinational Production in Cross-Country Risk Sharing∗

In this paper, we introduce the role of Multinational Production (MP) in cross-country risk sharing. We present a two-country, two-sector model with complete financial markets, and country-specific productivity shocks to the tradable sector. Firms can do MP by opening affiliates abroad which bear the productivity shock to the host country. By treating MP simultaneously as a portfolio and production flow, we find that MP affects the pattern of world risk even under the existence of a full set of contingent claims. MP changes TFP in the host country, affecting the impact of country-specific productivity shocks. Moreover, risk considerations increase the incentives of firms from large countries to do MP while the opposite happens for smaller economies. As a result, the model has predictions on the composition of international portfolios across countries: large countries have positive (net) position of Direct Investment while small economies hold positive (net) position of other financial assets. ∗We benefited from comments of participants at seminars in UC Berkeley, Columbia University, the Annual Meeting of the Society for Economic Dynamics (2007), Dartmouth International Trade Summer Camp (2007), FRB San Francisco, FRB Dallas, Harvard University, International Trade Workshop FRB Philadelphia (Fall 2007), U. Maryland, Penn State University, Stanford University, U. Texas-Austin, and Universidad de San Andres. For helpful comments, we thank George Alessandria, Hal Cole, Russell Cooper, Pierre-Olivier Gourinchas, Karen Lewis, Ellen McGrattan, Katheryn Russ, and Neng Wang. †E-mail: [email protected] ‡E-mail: [email protected]