The forward- and the equity-premium puzzles: two symptoms of the same illness?

• Main Author: Costa, Carlos Eugênio da
• Publication Date: 2012
• Other Authors: Issler, João Victor, Matos, Paulo Rogério Faustino
• Format: Article
• Language: eng
• Source: Repositório Institucional do FGV (FGV Repositório Digital)
• Download full: http://hdl.handle.net/10438/9706
• topic: Equity premium puzzle; Forward premium puzzle; Return-based pricing kernel; Economia; Risco (Economia) - Modelos econométricos

Using information on US domestic financial data only, we build a stochastic discount factor—SDF— and check whether it accounts for foreign markets stylized facts that escape consumption based models. By interpreting our SDF as the projection of a pricing kernel from a fully specified model in the space of returns, our results indicate that a model that accounts for the behavior of domestic assets goes a long way toward accounting for the behavior of foreign assets prices. We address predictability issues associated with the forward premium puzzle by: i) using instruments that are known to forecast excess returns in the moments restrictions associated with Euler equations, and; ii) by comparing this out-of-sample results with the one obtained performing an in-sample exercise, where the return-based SDF captures sources of risk of a representative set of developed and emerging economies government bonds. Our results indicate that the relevant state variables that explain foreign-currency market asset prices are also the driving forces behind U.S. domestic assets behavior.