Paper, Online Appendix
I study international risk sharing with limited stock market participation and preference heterogeneity in each country. An incomplete market model jointly generates high cross-country equity return correlation and low aggregate consumption growth correlation, while matching salient features of asset prices. The model further generates several implications that I show in the data: 1) The stockholders’ cross-country consumption growth correlation is considerably higher than that of the aggregate; 2) International bond flows help agents share the labor income risk only, while the country-specific financial income fluctuations are negatively correlated with equity inflows only; 3) The stockholders’ consumption risk is priced in both the home and foreign equity markets. I show that the financial integration significantly improves the stockholders’ welfare without benefiting the non-stockholders.
Using a structural model of default, we construct a measure of systemic default defined as the probability that many firms default at the same time. Our estimation accounts for correlations in defaults between firms through common exposures to shocks. The systemic default measure spikes during recession periods and is strongly correlated with traditional credit-based macroeconomic measures such as the default spread. Furthermore, our measure predicts future equity and corporate bond index returns, particularly at the one-year horizon, and even after controlling for many traditional return predictors such as the dividend yield, default spread, inflation, and tail risk. These predictability results are robust to out-of-sample tests.