Rotman ICPM / Netspar / Maastricht University Discussion Forum – October 2007 International Diversification and Labor Income Risk Giovanna Nicodano (jointly with Carolina Fugazza and Maela Giofrè) Collegio Carlo Alberto-CeRP / University of Turin Presented at the Joint Discussion Forum hosted by ICPM / Netspar / Maastricht University October 2007

Page 2Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Standard portfolio management practices based on mean variance analysis account for financial risk and overlook investors’ labor income risk –Efficient portfolio is the market portfolio Should they instead account also for labor income risk (LIR)?

Page 3Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Hedging LIR? “two-thirds of national product goes to labor, so human wealth is likely to be about two-thirds of total wealth and twice financial wealth... the omission of human wealth may be a serious matter “ Campbell, 1996 Labor income risk in portfolio choice models –mkt portfolio no longer efficient –optimal portfolio contains a LIR-hedging component, positive if return increases when wage growth falls Mayers, 1972, Bodie et al. 1992, Viceira, 2001

Page 4Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Hedging LIR in practice? Would actual portfolio shares be really different from the standard ones? Which assets should we consider? –First step: international equity diversification Which labor income risk should we focus on? Individual Cocco Gomes Maenhout 2005 Industry ? National Coen 2001

Page 5Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Industry– specific LIR inter-industry wage differentials are large and persist US: Dickens and Katz, 1987; Krueger and Summers, ; Weinberg, 2004 OECD: Gittleman and Wolff, 1993; Kahn, 1998 wage shocks at industry and national level display different cyclical pattern Blanchard and Fisher, 1989; Solon, Barsky and Parker, 1992

Page 6Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Industry–specific LIR Correlations between industry and national wage growth (98-04)

Page 7Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Industry-specific LIR CAPM with labor income risk improves Jagannathan and Wang 1996 R 2 = 29.32% no LIR R 2 = 55.21% with national LIR Larger improvement with industry-specific labor income risk - Eiling 2006 R 2 = 62% no LIR R 2 = 64% with national LIR R 2 = 75% with industry LIR

Page 8Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Motivation Industry-specific LIR Occupational pension funds –membership based on employment industry members face the same industry shocks Results shed light on whether pension funds should design portfolios to hedge labor income risk of their members –Caveat: classification of industry here does not with pension fund occupation; short sales allowed

Page 9Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Goal Assess to what extent LIR would affect international equity diversification –Compute and compare equilibrium portfolios no hedging of LIR –market shares hedging LIR for the representative national worker –restricted national portfolio hedging LIR for the representative industry worker in each country – industry portfolios for each investing country – unrestricted national portfolio for each investing country and inflation

Page 10Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Data Three investing countries - US, Canada and Italy Seven investing industries - Fin, Leisure, Manuf, Trade, Transports and Communic, Utilities, Other Services Ten destination countries - Can, F, I, J, Nl, Swe, UK, US, Ge, RoW Monthly observations of annual total returns on equities, wage growth rates and inflation Jan Dec 2004 WAGES  US - Current Employment Statistics  Canada - Survey of Employment Payrolls and Hours  Italy - Retribuzioni e Lavoro, ISTAT INFLATION  CPI indices- IMF International Financial Statistics STOCK RETURNS  Datastream Equity Indexes

Page 11Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Equity portfolio for investor s,l  *j s,l = speculative *j +inflation *j (l)+LIR *j (s,l) j equity hedges country j INFLATION if its return is positively correlated with j inflation j equity hedges LIR in industry s of country l when its return is negatively correlated with wage growth in s,l Merton (1971) with constant investment opportunities and background risk

Page 12Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Equilibrium portfolio for investor s,l  j s,l = market share j + inflation j (l)+LIR j (s,l) Inflation component is positive for equity j if the covariance of the j-th return with inflation in l exceeds the world average inflation covariance LIR component is positive for equity j when the covariance of the j-th return with wage in industry s of country l is lower than the world average wage covariance

Page 13Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Methodology Simulated empirical portfolio components market shares –observed in data at the end of 2004 inflation(l) –Regression of the inflation rate deviation on each equity index return LI(s,l) –Regression of the wage growth rate deviation on each equity index return deviation of country l inflation risk from the average world inflation risk deviation of industry s in country l wage risk from average world wage risk Cooper and Kaplanis, RFS 1994

Page 14Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Methodology Simulated empirical portfolios for each investing country l S industry s,l portfolios unrestricted national portfolio –weighted sum of S industry s,l portfolios Weight is the relative labor compensation in industry restricted national portfolio –portfolio suitable to hedge the average LIR in country l –intermediate risk aversion ( = 5) –fraction human wealth/total wealth ( η = 0.63)

Page 15Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results Compare Simulated portfolio shares invested in equity j Simulated labor income components –levels –pairwise statistical differences –When LIR is hedged at the industry level –When LIR is hedged at the country level reported results refer to statistically significant estimates

Page 16Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 1/ Optimal equity portfolios a. US ptf shares differ across industries

Page 17Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 1/ Optimal equity portfolios b. Canada

Page 18Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 1/ Optimal equity portfolios c. Italy lower heterogeneity

Page 19Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Result 2/ Inflation vs LIR H edging within country, labor hedging motive prevails on inflation hedging in all countries wrong inference based on hedging national LIR across countries, labor (and inflation) hedging motive is stronger for US and Canada weight is relative labor compensation in industrys,l

Page 20Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 3/ LIR hedging motives a. US labor hedging remarkable and heterogeneous across industries in US and Canada

Page 21Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 2/LIR hedging Canada & Italy

Page 22Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Heterogeneity Across Industries - Robustness 1. test the difference among labor income hedging coefficients across investing industries and count the # of significantly different coefficients – evaluate the statistically significant distance between the industry portfolios and the national one and derive a measure of dispersion of industry portfolios around the national portfolio

Page 23Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 3/ Hedging income risk at industry level Number of industry pairs with statistical different weights Test on differences between industry ptf weights for each industry pair

Page 24Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Results 3/ Industry vs National labor income hedging Confirmed higher heterogeneity in US and Canada wrt Italy conjecture: inversely correlated with EPL and centralized bargaining

Page 25Collegio Carlo Alberto- CeRP – International Diversification and Labor Income Risk Conclusions Sizeable labor hedging components in equity portfolios Substantial heterogeneity across industries –more pronounced for US and Canada Clear-cut role of occupational pension funds in hedging labor income risk - reduced where EP dampens industry wage shocks