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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 Rogério Faustino

Abstract

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 pricing Lustig and Verdelhan (2007)’s foreign currency portfolios. 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.

Suggested Citation

  • Costa, Carlos Eugênio da & Issler, João Victor & Matos, Paulo Rogério Faustino, 2010. "The forward- and the equity-premium puzzles: two symptoms of the same illness?," FGV/EPGE Economics Working Papers (Ensaios Economicos da EPGE) 712, FGV/EPGE - Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  • Handle: RePEc:fgv:epgewp:712
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    References listed on IDEAS

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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. 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.
    3. 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.
    4. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    5. 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.
    6. 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.
    7. 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.
    8. Jushan Bai, 2009. "Panel Data Models With Interactive Fixed Effects," Econometrica, Econometric Society, vol. 77(4), pages 1229-1279, July.
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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 Pós-Graduação em Economia [Brazilian Association of Graduate Programs in Economics].

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