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

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

Abstract

Using information on US domestic financial data only, we build a stochasticdiscount factor—SDF— and check whether it accounts for foreign marketsstylized facts that escape consumption based models. By interpreting ourSDF as the projection of a pricing kernel from a fully specified model in thespace of returns, our results indicate that a model that accounts for the behaviorof domestic assets goes a long way toward accounting for the behavior offoreign assets prices. We address predictability issues associated with the forwardpremium puzzle by: i) using instruments that are known to forecastexcess returns in the moments restrictions associated with Euler equations,and; ii) by comparing this out-of-sample results with the one obtained performingan in-sample exercise, where the return-based SDF captures sourcesof risk of a representative set of developed and emerging economies governmentbonds. 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.

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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 732.

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Date of creation: 24 Apr 2012
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Handle: RePEc:fgv:epgewp:732

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  1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  2. Korajczyk, Robert A. & Viallet, Claude J., 1992. "Equity risk premia and the pricing of foreign exchange risk," Journal of International Economics, Elsevier, vol. 33(3-4), pages 199-219, November.
  3. David K. Backus & Silverio Foresi & Chris I. Telmer, 1995. "Interpreting the Forward Premium Anomaly," Canadian Journal of Economics, Canadian Economics Association, vol. 28(s1), pages 108-119, November.
  4. Charles Engel, 1996. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  5. Hanno Lustig & Adrien Verdelhan, 2006. "Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 644-655, 04-05.
  6. Chauvet, Marcelle & Potter, Simon, 2000. "Coincident and leading indicators of the stock market," Journal of Empirical Finance, Elsevier, vol. 7(1), pages 87-111, May.
  7. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, vol. 15(3), pages 373-394, March.
  8. Jushan Bai, 2009. "Panel Data Models With Interactive Fixed Effects," Econometrica, Econometric Society, vol. 77(4), pages 1229-1279, 07.
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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] 180, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].

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