Table of contents
Table of figures ... II
Abstract ... III
1. Introduction ... 1
2. Fundamental theory and theoretical predictions ... 1
a. Relevance of risk sharing ... 1
b. Gains of diversification ... 2
c. Home Bias Puzzle ... 3
3. Empirical investigations of risk sharing in emerging markets ... 3
a. Consumption risk sharing ... 3
b. Impact of financial integration ... 6
c. Impact of default risk ... 7
d. Policy interventions and capital flows ... 8
e. Risk sharing and defaults in different subgroups ... 9
f. Relations between idiosyncratic output fluctuations and financial market developments ... 11
4. Lacks of international risk sharing ... 13
a. Why is there so little risk sharing in emerging markets? ... 13
b. Sensitivity of international risk sharing for financial integration under sovereign default risk ... 14
c. Country heterogeneity in cyclicality patterns ... 15
5. Conclusion ... 16
References ... IV
Appendix ... VI
Cyclicality of capital gains on domestic stock market ... XII
In light of ongoing financial integration and economic development, we investigate the influence of international risk sharing in terms of financial globalization for emerging markets. We see just little evidence of risk sharing in the last decades, but still come up with some persuasive inquiries to consider. Improvements in international risk sharing potentially lead to stabilizing effects, scarcer sudden stops and smaller risk premiums. Structural policy changes and better financial integration could surmount the threshold effect.
Feel free to use the following mind map as a compass to rank the factual connection right.
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Figure 1 Mind map to rank the factual connection
Is international risk sharing able to smooth uncertainties in the emerging markets? Will they catch up the distance to industrial countries? In this paper, we will investigate the potential of international risk sharing for emerging markets, particularly in terms of financial integration and liberalization.
Several government leaders all over the world recognize the potential of financial globalization for their country. If we take (Ibrahim, Dangote, & Kaberuka, 2017) as a highly topical example, we observe a strong incentive for deeper financial linking. Three of the development countries in Africa, already grew up to the so‑called emerging markets: Egypt, Morocco and South Africa. To keep up with the fast growing population and facilitating the economic growth, they want to stimulate employments for agriculture and infrastructure by investment partnerships with the G20. Whereas Donald Trump, the President of the USA, would like to cut funding World Bank programs like credit guarantees or small business access to finance for these countries. Indeed, these development countries, also including emerging markets, need to implement more structural changes like liberalizing financial markets and financial transparency for these intentions.
In this paper, we will survey if these incentives of financial integration, in terms of international risk sharing, indicate benefits for emerging market economies. In addition, we will investigate if huge foreign capital inflows show positive effects of risk sharing for them.
2. Fundamental theory and theoretical predictions
a. Relevance of risk sharing
Why is there an incentive to share risk internationally? Giving up a share of every day consumption expenses is a worse experience for most of the people. Even if the basic needs are satisfied, there is still some sort of luxury they do not want to miss. To serve this needs, they prefer a smooth, certain and predictable income stream. Countries, more precisely their governments, also have an incentive to reduce the volatility of their incomes. The challenge: economies evolve cyclical in the long‑term. One approach to smooth consumption is borrowing and lending. Expanding this idea will detect a trade-off between investment and consumption in closed economies, (Feenstra & Taylor, 2014, S. 225). These challenges lead to the investigations of international risk sharing with financial openness.
b. Gains of diversification
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Figure 2 Idiosyncratic and common shocks based on (Feenstra & Taylor, 2014, S. 239)
How can international risk sharing lead to smoothed income streams? To get a first intuition, we shortly look at a generalized example of (Feenstra & Taylor, 2014, S. 237 ff.).In this example, there are only two countries in this world with perfect negative correlated (ρ = –1) capital income streams. The volatility is caused by asymmetric country-specific idiosyncratic shocks. If both countries diversify their capital by investing 50% of their capital in the domestic portfolio and 50% in the foreign portfolio, each of them would generate a smoothed capital income stream, namely the average income stream. However, there might also be common shocks, which are symmetrical for both countries and result in a volatile world capital income stream, respectively average income stream. Under these assumptions of idiosyncratic and common shocks, the minimum volatility portfolio is located at a 50% fraction of foreign assets in our model, (Feenstra & Taylor, 2014, S. 240).
Is an equally weighted diversification of capital the best way to smooth the overall income streams? No, we need to implement the labor income, too. Diversifying labor in the same way as capital is not feasible, because that would be slavery. Nevertheless, we can substitute the share of labor with the share of capital in terms of diversification. Following this perception, the share of foreign assets needs to be adjusted. As an example, (Feenstra & Taylor, 2014, S. 238) calculate with 60% labor income and 40% capital income to compute the optimal portfolio allocation. Applying the assumptions, they calculate a minimum volatility portfolio of capital invested 100% in foreign assets <sup></sup>. This seems very improbable in practice, so we will see what the empirical research reveals.
c. Home Bias Puzzle
Many economists<sup></sup> detect a strong home bias of investors, who invest most of their capital in domestic assets<sup></sup>. Karen Lewis investigates the optimal portfolio diversification for the United States and found a risk‑return trade‑off. Depending on the risk‑return‑preferences, the optimal portfolio is allocated between 39% (minimum volatility portfolio) and 100% (local maximum) of foreign assets, (Lewis, 1999, S. 571 ff.).
<sup></sup> Actually it should even be 125% of capital in foreign assets, because they need to invest 50% capital income = 60% / 2 substituted labor income + 40% / 2 capital income, but only have 40% of capital income.
<sup></sup> One prominent example is (Lau, Ng, & Zhang, 2010).
<sup></sup> To explain these multifariously patterns more deeply is purpose of behavioral finance.
- Quote paper
- Julian Fischer (Author), 2017, International Risk Sharing and Gains from Financial Globalization, Munich, GRIN Verlag, https://www.grin.com/document/371885