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

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  • Matos, Paulo
  • Costa, Carlos Eugênio da
  • Issler, João Victor

Abstract

Using information on US domestic financial data only, we build a stochastic discountfactor—SDF— and check whether it accounts for foreign markets stylized factsthat escape consumption based models. By interpreting our SDF 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 long waytoward accounting for the behavior of foreign assets prices. We address predictabilityissues associated with the forward premium puzzle by: i) using instruments that areknown to forecast excess returns in the moments restrictions associated with Eulerequations, and; ii) by pricing Lustig and Verdelhan (2007)’s foreign currency portfolios.Our results indicate that the relevant state variables that explain foreign-currencymarket asset prices are also the driving forces behind U.S. domestic assets behavior.

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 649.

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Date of creation: 01 Aug 2007
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Handle: RePEc:fgv:epgewp:649

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  1. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive, David K. Levine 1401, David K. Levine.
  2. Jushan Bai, 2009. "Panel Data Models With Interactive Fixed Effects," Econometrica, Econometric Society, Econometric Society, vol. 77(4), pages 1229-1279, 07.
  3. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  4. Hanno Lustig & Adrien Verdelhan, 2005. "Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution," Boston University - Department of Economics - Working Papers Series, Boston University - Department of Economics WP2005-040, Boston University - Department of Economics.
  5. David Backus & Silverio Foresi & Chris Telmer, . "Interpreting the Forward Premium Anomoly," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 15, Carnegie Mellon University, Tepper School of Business.
  6. Korajczyk, Robert A. & Viallet, Claude J., 1992. "Equity risk premia and the pricing of foreign exchange risk," Journal of International Economics, Elsevier, Elsevier, vol. 33(3-4), pages 199-219, November.
  7. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, Elsevier, vol. 15(3), pages 373-394, March.
  8. Chauvet, Marcelle & Potter, Simon, 2000. "Coincident and leading indicators of the stock market," Journal of Empirical Finance, Elsevier, Elsevier, vol. 7(1), pages 87-111, May.
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Cited by:
  1. Andrei G. Simonassi, 2006. "Estimando A Taxa De Retorno Livre De Risco No Brasil," Anais do XXXIV Encontro Nacional de Economia [Proceedings of the 34th Brazilian Economics Meeting], ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of G 180, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].

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