International diversification, growth, and welfare with non-traded income risk and incomplete markets

Egil Matsen

Applied Financial Economics, 2005, vol. 15, issue 15, 1063-1072

Abstract: The study asks how the potential benefits from cross-border asset trade are affected by the presence of non-traded income risk in incomplete markets. It is shown 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. It is also shown that international asset trade increases welfare if it increases the risk-adjusted growth rate. This is always the case in the 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.

Date: 2005
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Working Paper: International Diversification, Growth, and Welfare with Non-Traded Income Risk and Incomplete Markets (2002)
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DOI: 10.1080/09603100500120670

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