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A Note on the Forward- and the Equity-Premium Puzzles: Two Symptoms of the Same Illness?

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

We build a stochastic discount factor—SDF— using information on US domestic financial data only, and provide evidence that it accounts for foreign markets stylized facts that escape SDF’s generated by consumption based models. By interpreting our SDF as the projection of the 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. In our tests, we address predictability, a defining feature of the Forward Premium Puzzle—FPP— by using instruments that are known to forecast excess returns in the moments restrictions associated with Euler equations both in the equity and the foreign markets.

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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 743.

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Date of creation: 12 Jul 2013
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Handle: RePEc:fgv:epgewp:743
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  1. Lustig, H. & Verdelhan, A., 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Working papers 155, Banque de France.
  2. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  3. Christoph Thoenissen, 2008. "Exchange rate dynamics, asset market structure and the role of the trade elasticity," CDMA Working Paper Series 200803, Centre for Dynamic Macroeconomic Analysis.
  4. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
  5. John H. Cochrane, 2006. "The Dog That Did Not Bark: A Defense of Return Predictability," NBER Working Papers 12026, National Bureau of Economic Research, Inc.
  6. Barbara Rossi, 2005. "Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability," Data 0503001, EconWPA.
  7. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
  8. Brandt, Michael W. & Cochrane, John H. & Santa-Clara, Pedro, 2006. "International risk sharing is better than you think, or exchange rates are too smooth," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 671-698, May.
  9. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  10. 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 WP2005-040, Boston University - Department of Economics.
  11. Iwata, Shigeru & Wu, Shu, 2006. "Macroeconomic Shocks And The Foreign Exchange Risk Premia," Macroeconomic Dynamics, Cambridge University Press, vol. 10(04), pages 439-466, September.
  12. Kim, Sunghyun Henry & Kose, M. Ayhan, 2003. "Dynamics Of Open-Economy Business-Cycle Models: Role Of The Discount Factor," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 263-290, April.
  13. Modjtahedi, Bagher, 1991. "Multiple maturities and time-varying risk premia in forward exchange markets : An econometric analysis," Journal of International Economics, Elsevier, vol. 30(1-2), pages 69-86, February.
  14. Fama, Eugene F., 1984. "Term premiums in bond returns," Journal of Financial Economics, Elsevier, vol. 13(4), pages 529-546, December.
  15. Frankel, Jeffrey A., 1979. "The diversifiability of exchange risk," Journal of International Economics, Elsevier, vol. 9(3), pages 379-393, August.
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