No. 17/2002
INTERNATIONAL DIVERSIFICATION, GROWTH, AND WELFARE WITH NON-TRADED INCOME
RISK AND INCOMPLETE MARKETS
Egil Matsen
Abstract:
We ask how the potential benefits from cross-border asset trade are affected
by the presence of non-traded income risk in incomplete markets. We show
that the mean consumption growth may be lower with full integration than
in financial autarky. This can occur because: the hedging demand for risky
high-return projects may fall as the investment opportunity set increases,
and precautionary savings may fall as the unhedgeable non-traded income
variance decreases upon financial integration. We also show that international
asset trade increases welfare if it increases the risk-adjusted growth
rate. This is always the case in our model, but the effect may be close
to negligible. The welfare gain is smaller the higher the correlation
between the domestic non-traded income process and foreign asset returns.
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