Essays on International Finance and Risk Sharing

The potential for economic agents to minimize risk through diversification is central to the study of finance. This dissertation analyzes the ability to diversify risks in an international context by studying risk sharing opportunities on two dimensions, consumption growth and portfolio wealth. The first part of this dissertation examines the ability for US based investors to diversify their portfolio risks by incorporating international corporate bonds. Based on a mean variance framework, I study the potential portfolio gains to US investors of holding foreign corporate bonds. Further, I ask if the current observed portfolio holdings match the computed optimal holdings. Using statistical analysis both with and without estimation risk, I find that comparable to the well documented phenomenon in equity markets, a similar home bias can also be found in corporate bond markets. I also investigate the hypothesis that investors can substitute direct investment in foreign corporate bond markets by holding US corporate bonds issued by foreign firms. Contrary to emerging market equity markets, I find that corporate bonds issued by foreign firms that trade in the US are insufficient to capture the gains of directly investment in the foreign corporate bond markets. The second part of this dissertation shifts focus and studies the potential welfare gains for countries to share consumption risks, when there is a small but persistent shock in the consumption growth rate. I find that a long run risk to their consumption growth has the ability to generate large welfare gains from international diversification. Further, when I estimate the model parameters using simulate method of moments, I find a large disparity in model parameter estimates across my sample of countries, which would lead to large departures in welfare gains away from a equal consumption share.