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 exceeds 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.