International Risk Sharing is Better Than You Think (or Exchange Rates are Much Too Smooth!
Exchange rates depreciate by the difference between the domestic and foreign marginal utility growths. Exchange rates vary a lot, st of the variation of average stock risk through time and it is idiosyncratic risk that drives the forecastability of the stock market.” as much as 10% per year. However, equity premia imply that marginal utility growths vary much more, by at least 50% per year. This means that marginal utility growths must be highly correlated across countries - international risk sharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do - exchange rates are much too smooth. We calculate an index of international risk sharing that formalizes this intuition in the context of both complete and incomplete capital markets. Our results suggest that risk sharing is indeed very high across several pairs of countries.”