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

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.