Risks for the long run: An explanation of international finance puzzles

Brandt, Cochrane and Santa Clam (2004) pointed out that the implicit stochastic discount factors computed using prices, on the one hand, and consumption growth, on the other hand, have very different implications for their cross country correlation. They leave this as an unresolved puzzle. We explai...

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Bibliographic Details
Main Author Colacito, Riccardo
Format Dissertation
LanguageEnglish
Published ProQuest Dissertations & Theses 01.01.2006
Subjects
Arbitrage
Calibration
Consumption
Copyright
Currency
Econometrics
Economic growth
Elasticity
Equity
Finance
Foreign exchange rates
Interest rates
International finance
Preferences
Prices
Puzzles
Risk aversion
Risk sharing
Securities markets
Standard deviation
Stochastic models
Stock exchanges
Studies
Volatility
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Summary:Brandt, Cochrane and Santa Clam (2004) pointed out that the implicit stochastic discount factors computed using prices, on the one hand, and consumption growth, on the other hand, have very different implications for their cross country correlation. They leave this as an unresolved puzzle. We explain it by combining Epstein and Zin (1989) preferences with a model of predictable returns and by positing a very correlated long run component. We also assume that the intertemporal elasticity of substitution is larger than the reciprocal of the coefficient of risk aversion, implying a preference for early resolution of uncertainty. This setup brings the stochastic discount factors computed using prices and quantities close together, by keeping the volatility of the depreciation rate in the order of 12% and the cross country correlation of consumption growth around 30% We also provide an econometric analysis of the model, by showing that the over-identifying restrictions imposed by financial variables allow us to associate tight confidence intervals to parameters of the consumption process that would otherwise be undetectable. To conclude we generalize the model to provide a unified solution of a number of international finance puzzles including the Backus and Smith (1993) puzzle and the tendency of high interest rate currencies to appreciate.
ISBN:0542877414
9780542877414