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I develop a theory of risk diversification through geography, where risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of sales. Both the probability of entry and trade flows to a market are increasing in the “Diversification Index”, which depends on the multilateral covariance of a country's demand with all other markets. The firms’ risk diversification behavior may imply higher welfare gains from trade than in standard trade models. Risk-augmented gravity regressions show that demand risk significantly affects trade patterns. The risk diversification channel increases welfare gains from trade by 16% relative to models with risk neutrality. The quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent Chinese boom.

Demand Risk and Diversification through Trade