Stock volatility and correlations in dynamic general equilibrium models

Why are international equity market correlations low? Cross-country equity returns tend to have low correlation. Even diversification across countries within an industry is a much more effective tool for risk reduction than industry diversification within a country. I explore the underlying sources of the low international correlations in a benchmark general equilibrium model. In equilibrium, domestic industry return correlations exceed the return correlations in international equity markets even with frictionless financial and product markets. The high domestic correlations result from the relative price movements in the product markets. A productivity shock to one industry makes all other industries better off by increasing the relative prices of their products. Consequently, cross-industry stock return correlations considerably exceed the correlations of fundamental outputs. When the output correlations are calibrated to the data, the model generates return correlations consistent with the empirical findings. Relative price movements remain to be a dominant factor in driving the return correlations even after various frictions are imposed on the financial product markets.; Risk sharing and counter-cyclical variation in market correlations . I present a consumption-based dynamic asset pricing model in which international market correlations vary counter-cyclically over time. The driving force in the model is the time-varying effective risk aversion induced by external habit formation. Market returns are driven by fundamental outputs and discount rates. When risk aversion is high, the effect of discount rates on market returns rises with the market price of risk. To the extent that countries share risk, the cross-country correlation of discount rates exceed the cross-country correlation of fundamental outputs. In bad times, market correlations rise as returns are mostly driven by discount rates. Thus, consistent with the empirical evidence, periods of high risk aversion are associated with high market correlations and high market volatility. After calibration, my model is consistent with the observed variation in market correlations, as well as other features of asset prices including the equity premium and market volatility.; The leverage effect and the dynamics of stock volatility. We quantify the leverage effect on stock return volatility in a general equilibrium asset pricing economy. Our analysis is at both the market and the individual firm levels. An asset pricing economy with constant riskfree rate and market price of risk fails to capture the observed features of asset prices. In that case, financial leverage generates very little variation in the stock volatility at the market level but significant variation at the individual firm level. When there is a realistic variation in the pricing kernel, consistent with the observed features of asset prices, we find that the leverage effect is small at both the market and the individual firm levels. Time-varying interest rates and market price of risk are the main driving forces behind the dynamics of stock volatility.