Rotman ICPM / Netspar / Maastricht University Discussion Forum – October 2007 International Diversification and Labor Income Risk Giovanna Nicodano (jointly.

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 byICPM / 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)?


MotivationHedging 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


MotivationHedging 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 2005Industry ?National Coen 2001


MotivationIndustry– specific LIR

• inter-industry wage differentials are large and persist

•US: Dickens and Katz, 1987; Krueger and Summers, 1987-88; 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


MotivationIndustry–specific LIR

Correlations between industry and national wage growth (98-04)

trade util transp other manufact fin leisure

0.67 0.13 -0.15 0.62 -0.33 0.71 0.80

-0.14 -0.42 0.00 0.73 0.50 0.38 0.55

0.01 0.38 0.38 0.18 0.73 0.27 0.31

USA

Canada

Italy


MotivationIndustry-specific LIR

• CAPM with labor income risk improves Jagannathan and Wang 1996

•R2 = 29.32% no LIR•R2 = 55.21% with national LIR

• Larger improvement with industry-specific labor income risk - Eiling 2006

•R2 = 62% no LIR•R2 = 64% with national LIR•R2 = 75% with industry LIR


MotivationIndustry-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


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


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 1998- Dec 2004

WAGES US - Current Employment Statistics Canada - Survey of Employment Payrolls and Hours Italy - Retribuzioni e Lavoro, ISTAT

INFLATIONCPI indices- IMF International Financial Statistics

STOCK RETURNS Datastream Equity Indexes


Equity portfolio for investors,l

*js,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


Equilibrium portfolio for investors,l

js,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


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 countryl inflation risk from the average world inflation risk

deviation of industrys in countryl wage risk from average world wage risk

Cooper and Kaplanis, RFS 1994


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)


ResultsCompare• 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


Results 1/ Optimal equity portfolios a. US• ptf shares differ across industries

National National

restricted trade util transp other manufact fin leisure unrestricted

Ca 0.03 0.15 0.24 0.30 0.14 0.08 0.04 0.13 0.25 0.12Fr 0.05 0.04 0.17 0.17 0.17 -0.05 0.29 0.17 0.17 0.14It 0.02 0.09 -0.02 -0.02 -0.02 0.16 -0.10 0.10 0.11 0.06Jp 0.11 0.16 0.11 0.19 0.11 0.18 0.05 0.11 0.11 0.12Nl 0.02 0.02 0.02 0.02 0.36 0.02 -0.17 -0.24 0.02 -0.10Sw 0.01 -0.05 -0.10 -0.33 0.09 -0.05 0.08 -0.08 -0.13 -0.05UK 0.09 0.09 0.09 -0.15 0.09 0.09 0.16 0.09 -0.08 0.09US 0.42 0.32 0.30 0.38 0.38 0.32 0.50 0.30 0.28 0.34Ge 0.04 0.04 0.09 0.30 -0.27 0.09 -0.12 -0.04 0.09 -0.01Rest 0.22 0.22 0.22 0.12 0.10 0.22 0.22 0.28 0.22 0.24T-bill - -0.07 -0.09 0.02 -0.15 -0.06 0.05 0.17 -0.05 0.04

Investing IndustriesEquity Indices

Market Share


Results 1/ Optimal equity portfolios b. Canada


Ca 0.03 0.10 0.14 0.24 0.21 0.10 0.16 0.00 0.10 0.11Fr 0.05 0.05 0.05 0.05 0.05 0.05 0.24 0.05 -0.54 0.05It 0.02 0.18 0.18 0.18 0.18 0.28 0.06 0.18 1.06 0.24Jp 0.11 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.42 0.21Nl 0.02 0.02 0.20 0.02 -0.20 -0.19 0.02 0.02 -0.76 -0.08Sw 0.01 -0.09 -0.09 -0.09 -0.09 -0.09 -0.09 0.07 -0.29 -0.08UK 0.09 0.09 -0.04 0.09 0.24 -0.04 0.09 0.29 0.09 0.06US 0.42 0.39 0.33 0.09 0.33 0.56 0.33 0.33 0.33 0.41Ge 0.04 0.11 0.11 0.31 0.11 0.11 0.11 0.11 0.49 0.14Rest 0.22 0.22 0.22 0.22 0.22 0.22 0.22 0.22 0.40 0.23T-bill - -0.26 -0.31 -0.30 -0.24 -0.19 -0.34 -0.47 -0.31 -0.29

Equity Indices

Market Share

Investing IndustriesNational restricted

National unrestricted


Results 1/ Optimal equity portfolios c. Italy• lower heterogeneity


Ca 0.03 0.09 0.03 0.20 0.20 0.03 0.12 0.03 0.21 0.08Fr 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.26 0.05 0.08It 0.02 0.02 0.02 -0.17 0.02 0.02 0.02 -0.18 0.02 -0.01Jp 0.11 0.11 0.11 0.11 0.11 0.11 0.11 0.11 0.11 0.11Nl 0.02 -0.07 -0.07 -0.07 -0.07 -0.07 -0.07 -0.07 -0.07 -0.07Sw 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01UK 0.09 0.09 0.09 0.09 -0.17 0.09 0.09 0.30 -0.19 0.09US 0.42 0.49 0.42 0.42 0.42 0.51 0.42 0.56 0.42 0.47Ge 0.04 0.12 0.12 0.12 0.25 0.12 0.12 -0.05 0.12 0.10Rest 0.22 0.17 0.22 0.06 0.11 0.22 0.13 0.14 0.09 0.17T-bill - -0.07 0.00 0.18 0.08 -0.08 0.00 -0.10 0.22 -0.02

Equity Indices

Market Share

National restricted

Investing Industries National unrestricted


Result 2/ Inflation vs LIR Hedging

• 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

industry wgt av

national restr.

industry wgt av

national restr.

industry wgt av

national restr.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)Ca 0.05 0.06 0.08 0.07 0.04 - - 0.05 0.06 0.03Fr 0.12 0.07 0.13 - 0.07 - - 0.04 - 0.05It 0.05 0.11 0.11 0.16 0.11 - - 0.04 - 0.02Jp - 0.03 0.05 0.09 0.01 - - - - 0.11Nl - 0.15 - - 0.16 - 0.09 - - 0.02Sw - 0.08 0.06 0.10 0.04 - - - - 0.01UK - 0.02 - - 0.10 - - 0.07 - 0.09US 0.04 0.08 0.07 0.09 0.08 0.06 - 0.05 0.06 0.42Ge 0.08 0.08 0.09 0.08 0.02 - 0.09 0.04 - 0.04Rest - 0.03 - - 0.01 - - 0.05 0.05 0.22

sum hedge 0.33 0.71 0.58 0.59 0.64 0.06 0.18 0.32 0.17

Abs Labor HedgeUS Canada Italy

Market Share

Abs Labor Hedge Abs Labor HedgeInfl

HedgeInfl

HedgeInfl

Hedge

weight is relative labor compensation in industrys,l


Results 3/ LIR hedging motivesa. US

• labor hedging remarkable and heterogeneous across industries in US and Canada

trade util transp other manufact fin leisureCa 0.16 0.22 0.07 - -0.04 0.06 0.18Fr - - - -0.22 0.12 - -It - - - 0.18 -0.08 0.12 0.13Jp - 0.08 - 0.07 -0.06 - -Nl - - 0.35 - -0.19 -0.26 -Sw -0.12 -0.34 0.08 -0.06 0.07 -0.09 -0.14UK - -0.24 - - 0.08 - -0.17US -0.09 - - -0.06 0.12 -0.08 -0.10Ge 0.13 0.34 -0.23 0.13 -0.08 - 0.13Rest - -0.10 -0.12 - - 0.07 -

Labor Hedge


Results 2/LIR hedging Canada & Italy

trade util transp other manufact fin leisureCa 0.04 0.14 0.11 - 0.06 -0.10 -Fr - - - - 0.20 - -0.59It - - - 0.10 -0.12 - 0.87Jp - - - - - - 0.23Nl 0.19 - -0.22 -0.21 - - -0.78Sw - - - - - 0.16 -0.20UK -0.13 - 0.15 -0.12 - 0.20 -US - -0.24 - 0.22 - - -Ge - 0.20 - - - - 0.38Rest - - - - - - 0.19

Labor Hedge

trade util transp other manufact fin leisureCa - 0.17 0.17 - 0.09 - 0.18Fr - - - - - 0.21 -It - -0.19 - - - -0.20 -Jp - - - - - - -Nl - - - - - - -Sw - - - - - - -UK - - -0.26 - - 0.21 -0.27US - - - 0.08 - 0.13 -Ge - - 0.13 - - -0.18 -Rest - -0.16 -0.11 - -0.08 -0.08 -0.13

Labor Hedge


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


Results 3/Hedging income risk at industry level

Number of industry pairs with statistical different weights

Number of industry pairs with statistical different weights

Test on differences between industry ptf weights for each industry pair

Figure 1. US industries 48% statistically significant differences

0

2

4

6

8

10

0 1 2 3 4 5 6 7 8 9 10

# different coeffs

# in

du

stry

-pai

rs

Figure 2. Canadian industries 44% statistically significant differences

0

2

4

6

8

10

0 1 2 3 4 5 6 7 8 9 10

# different coeffs

# in

du

stry

-pai

rs

Figure 3. Italian industries 28% statistically significant differences

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7 8 9 10

# different coeffs

# in

du

stry

-pai

rs


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

US Canada Italy

sd weighted 0.10 0.13 0.07 sd unweighted 0.11 0.19 0.08

range (0.04-0.37) (0.03-0.87) (0.03-0.26)


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

Rotman ICPM / Netspar / Maastricht University Discussion Forum – October 2007 International Diversification and Labor Income Risk Giovanna Nicodano (jointly.

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