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Does financial integration affect real exchange rate volatility and cross-country equity market returns correlation?

Michael Donadelli and Antonio Paradiso ()

The North American Journal of Economics and Finance, 2014, vol. 28, issue C, 206-220

Abstract: Existing empirical studies show that financial integration affects the behavior of average excess returns, cross-country equity market returns (EMR) correlations and real exchange rate (RER) volatility. We employ a recently developed two-country model with recursive preferences, frictionless and complete markets and highly correlated long-run innovations to examine whether full financial integration (i.e. full risk-sharing) affects the US-Canada EMR correlation and the US RER volatility, consistently with existing empirical findings. First, full risk-sharing gives rise to a relatively high RER volatility. Second, it induces very strong positive cross-country EMR correlations. Both quantities are higher than those observed in the US-Canada asset pricing data, and increase as the risk-sharing incentive increases. In contrast, “international consumption quantities” are weakly sensitive to changes in the level of aversion to consumption and utility risk.

Keywords: Financial integration; Risk-sharing; Cross-country equity returns correlation; Real exchange rate volatility (search for similar items in EconPapers)
Date: 2014
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