Trend Shocks, Risk Sharing and Cross-Country Portfolio Holdings

Abstract

This paper analyzes the dynamics of risk premia, real exchange rates and portfolio movements in a two-country, two-good, two-bond model. We use an asymmetric set-up in the model, where one of the countries is emerging and the other one is developed and both countries issue bonds in domestic currency. The emerging country differs from the developed country in that it is subject to trend shocks and it is more risk averse. We find that the trend shocks produce strong wealth effects for the emerging country, and as a result, the terms of trade and the real exchange rate appreciate. Appreciation of the terms of trade breaks the hedging opportunities coming from international trade in goods. In contrast, the appreciation of the real exchange rate generates new hedging opportunities in international financial markets for both countries. Therefore, our model can endogenously generate large portfolio holdings. And differences in the risk aversion across countries lead to net positive foreign asset positions and significant risk premia in the emerging country. Moreover, the relative volatilities and cyclicalities of risk premia and real exchange rates improve significantly and move closer to the observed values in the data and our model can account for the lack of international risk sharing.