Consumption, Stock Returns, and the Gains from International Risk-Sharing

Whether this lack of diversification is important depends on the potential gains from risk-sharing. General equilibrium models and consumption data tend to find that the costs are small, typically less than 0.5 percent of permanent consumption. On the other hand, stock returns imply gains that are several hundred times larger. In this paper, the author examines the reasons for these differences and finds that the primary differences are due to (a) the much higher variability of stocks, and/or (b) the higher degree of risk aversion required to reconcile an international equity premium. Furthermore, contrary to conventional wisdom, treating stock returns as exogenous does not necessarily imply greater gains.