The Forward- and the Equity-Premium Puzzles: Two Symptoms of the Same Illness?

Carlos Eugênio da Costa, João Victor Issler and Paulo F. Matos

No 697, Economics Working Papers (Ensaios Economicos da EPGE) from Graduate School of Economics, Getulio Vargas Foundation (Brazil)

Abstract: We build a pricing kernel using only US domestic assets data and checkwhether it accounts for foreign markets stylized facts that escape consumptionbased models. By interpreting our stochastic discount factor as the projection ofa pricing kernel from a fully specified model in the space of returns, our results indicatethat a model that accounts for the behavior of domestic assets goes a longway toward accounting for the behavior of foreign assets. We address predictabilityissues associated with the forward premium puzzle by: i) using instrumentsthat are known to forecast excess returns in the moments restrictions associatedwith Euler equations, and; ii) by pricing Lustig and Verdelhan (2007)'s foreigncurrency portfolios. Our results indicate that the relevant state variables that explainforeign-currency market asset prices are also the driving forces behind U.S.domestic assets behavior.

New Economics Papers: this item is included in nep-dge, nep-ifn and nep-upt
Date: 2009-08-12

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Persistent link: http://EconPapers.repec.org/RePEc:fgv:epgewp:697

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