DP14230 Global Risk Sharing through Trade in Goods and Assets: Theory and Evidence

Author(s): Inga Heiland
Publication Date: December 2019
Keyword(s): Global Risk Sharing, international trade, structural gravity
JEL(s): F15, F36, F44, G11
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14230

Exporting not only provides firms with profit opportunities, but can also provide for risk diversification if demand is imperfectly correlated across countries. This paper shows that the correlation pattern of demand shocks across countries constitutes a hitherto unexplored source of comparative advantage that shapes trade flows and persists even if financial markets are complete. With exporters making market- specific choices under uncertainty, countries whose shocks are riskier, in the sense that they contribute more to aggregate volatility, are less attractive destinations for both investment and exports. A gravity-type regression lends support to the hypothesis that, conditional on trade costs and market size, exporters sell smaller quantities in riskier destinations. I develop a general equilibrium trade model, with risk-averse investors and complete asset markets, which rationalizes this novel fact. A counterfactual experiment shows that risk-based comparative advantage accounts for 4.6% of global trade. Country-level exports would grow by -13% to +10% if all diversification opportunities were eliminated, entailing welfare losses in the range of .4% to 16%.