CFDP 1239

World Income Components: Measuring and Exploiting Risk-Sharing Opportunities

Author(s): 

Publication Date: October 1999

Pages: 43

Abstract: 

We provide a method for decomposing the variance of changes in incomes in the world into components, world income components (WICs), in such a way as to indicate the most important risk-sharing opportunities among people of the world. We develop a constant absolute risk premium model, an intertemporal general equilibrium model of the world that facilitates consideration of optimal contract design. We show that for a contract designer maximizing a social welfare function, the optimal risk-management contracts maximize the equilibrium world real interest rate. That is the contract designer achieves the risk-optimal interest rate. We show that these WIC securities are defined in terms of eigenvectors of a transformed variance matrix of income changes. The method is applied with a variance matrix estimated using Penn World Table data on the G-7 countries, 1950-92.

Keywords: 

Constant Absolute Risk Premium, risk-optimal interest rate, three-level income model, WIC securities, contract design, macro markets, hedging

See CFP: 1029