Trend Shocks, Risk Sharing and Cross-Country Portfolio Holdings

Yavuz Arslan, Gursu Keles and Mustafa Kilinc

Working Papers from Research and Monetary Policy Department, Central Bank of the Republic of Turkey

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 di�ers 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 e�ects 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 di�erences in the risk aversion across countries lead to net positive foreign asset positions and signi?cant 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.

Keywords: Risk sharing; Risk premium; Exchange rates; Trend shocks; Portfolio movements (search for similar items in EconPapers)
JEL-codes: F34 F41 F44 G15 (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-ias and nep-opm
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:tcb:wpaper:1205

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