Limited risk sharing and international equity returns

Abstract

I study international consumption risk sharing with limited stock market participation in each country. I present new evidence, employing micro-level household consumption data in the U.S. and U.K., showing that stockholders' consumption growth correlation is considerably higher than that of the aggregate consumption growth. Empirically, for stock markets that are integrated with the U.S. market (such as European markets), U.S. stockholders long-run consumption growth can explain its equity cross-section, but not that of segmented markets. I construct an incomplete market model that features limited risk sharing within each country due to limited stock market participation. Besides matching the salient features of asset prices (high and volatile equity premium, low and smooth risk free rate), the model quantitatively rationalizes the empirical evidence above, as well as the low aggregate consumption growth correlation and high asset return correlation. The model suggests that financial integration significantly reduces the consumption volatility of the stockholders and the amount of aggregate risks borne by them, hence improves their welfare. However, the benefits are almost all captured by the stockholders.