Risk Aversion, Wealth and International Capital Flows

Abstract

This paper models capital flows in a rich–poor, two‐country, two‐asset, dual‐risk economy with decreasing absolute risk aversion. The first risk is asset‐specific. The second is political and dependent; i.e., related to particular asset outcomes. In this framework, the role of wealth in determining asset preferences is demonstrated, and the conditions for diversification are derived. The wealth effect and diversification conditions are applied to explain ongoing two‐way capital flows in general as well as the apparent paradox of domestic capital flight with simultaneous inflows of foreign capital.