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Risk and Return in Bond, Currency and Equity Markets

An extensive list of financial puzzles commonly includes the level and volatilities of the nominal yields, failure of the expectations hypothesis in bond and foreign exchange markets (see Fama, 1984; Campbell and Shiller, 1991), exchange rate volatility, and the risk premium and stock-price volatility puzzles in equity markets.

Absence of arbitrage opportunities implies that concerns about the same fundamental sources of risks should simultaneously account for prices of assets in all financial markets. In this paper we present a unified long-run risks framework that provides an integrated explanation of bond, currency, and equity market anomalies.

Specifically, we rely on the long-run risks model of Bansal and Yaron (2004), who largely focus on the equity premium and risk free rate puzzles. The key ingredients of the model is a small and persistent low-frequency component in consumption growth rate and a time-varying volatility of consumption growth. To price claims in nominal terms, we also model the inflation process for each country.

The preferences of the representative agent are characterized by a non-expected recursive utility considered by Kreps and Porteus (1978), in a convenient parametrization of Epstein and Zin (1989). These preferences allow for a separation between risk aversion and intertemporal elasticity of substitution (IES) of investors; in our specification, agents have preference for early resolution of uncertainty, which increases the risk compensation for long-run growth and uncertainty risks.

Risk and Return in Bond, Currency and Equity Markets