Asset Prices and Risk Sharing. The Valuation Effects of Capital Market Integration

Giancarlo Corsetti, Anna Lipinska and Giovanni Lombardo
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Giovanni Lombardo: Bank for International Settlements

No 679, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Gains from trade in assets can always be decomposed into a consumption smoothing (volatility) and valuation (average) term. The latter follows from the changes in the present discounted value of domestic output when this is re-valued at the new equilibrium (state contingent) prices. We show that even when theory restricts the overall gains to be positive, either the smoothing or the valuation term may be negative, per effect of asymmetries in economic size and risk. We also point out that omitting the specification of the budget constraint in complete market models, a widespread practice in the quantitative literature, leads to substantial bias in welfare assessment. We provide a method to redress this problem in an accurate and efficient way.

Date: 2019
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