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A NOTE ON THE FORWARD AND THE EQUITY PREMIUM PUZZLES: TWO SYMPTOMS OF THE SAME ILLNESS?

Published online by Cambridge University Press:  11 November 2013

Carlos E. da Costa ,
João V. Issler  and
Paulo F. Matos
Carlos E. da Costa
Affiliation:
FGV/EPGE
João V. Issler*
Affiliation:
FGV/EPGE
Paulo F. Matos
Affiliation:
UFC/CAEN
*
Address correspondence to: João V. Issler, Escola de Pós-Graduação em Economica da Fundação Getulio Vargas, Praia de Botafogo, 190 11o andar, Rio de Janeiro, RJ 22250-900, Brazil; e-mail: jissler@fgv.br.
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Abstract

We build a stochastic discount factor—SDF—using U.S. domestic financial data only, and provide evidence that it accounts for stylized facts about foreign markets that escape SDFs generated by consumption-based models. When our SDF is interpreted 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 asset 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 moment restrictions associated with Euler equations both in the equity and in the foreign markets.

Keywords

Equity Premium PuzzleForward Premium PuzzleReturn-Based Pricing Kernel
Type
Notes
Information
Macroeconomic Dynamics , Volume 19 , Issue 2 , March 2015 , pp. 446 - 464
Copyright
Copyright © Cambridge University Press 2013 

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