Where do individuals choose to hold capital? Using what class of assets? What does their strategy achieve? Typical answers almost unanimously show that the international allocation of capital depends on the institutional and regulatory context, and observed investment does not seem to achieve much by way of diversification. The extent of international risk sharing appears to remain limited, and, according to Lewis (1996), largely driven by de jure restrictions to international capital flows. We argue that these conclusions, while true, obscure empirical regularities implying conditional relations between the regulatory environment, institutions, the composition of international investment portfolio, and the extent of risk sharing.
Our purpose is to improve in two dimensions the conventional test of international consumption risk sharing introduced by Lewis (1996). First, do diversification gains depend on the magnitude and the composition of international investment across various asset classes? If differences exist, why do they arise? Second, can one use information on bilateral capital flows to investigate the extent of risk insurance between pairs of countries? This provides an attractive alternative to considering the multilateral problem faced by a small open economy, especially when data on bilateral financial linkages are becoming readily available.
Numerous contributions in finance have made it clear that imposing no arbitrage restrictions in empirical models of the yield curve improves their empirical characteristics (see e.g. Ang et al. 2006 for a recent example). At the same time, macroeconomic research has shown that theoretical restrictions embedded in dynamic stochastic general equilibrium (DSGE) models make current macro models competitive with VARrs (see e.g. Smets and Wouters 2007). The macro)finance literature aims to combine these two types of restrictions, in view of capturing both dimensions simultaneously, and ultimately, contribute to understanding links between the real and financial economy.
The high default rates and massive downgrades of seemingly high quality (e.g., AAA-rated) Mortgage backed Securities in 2007 and 2008 hit financial markets and investors by surprise during the Global Financial Crisis (GFC). Models applied by credit rating agencies (CRA) along with misaligned incentives based on ‘paid-by-originator’- business models have been blamed as major sources of the crisis (compare Hellwig 2008, Hull 2009, Crouhy et al. 2008).
