Equity Premiums In Small Open Economy

Douch, Mohamed (2004): Equity Premiums In Small Open Economy.

Abstract

It is now well known that the RBC models have enjoyed successful results in explaining the dynamics of the business cycle variables but fail to replicate similar interesting stylized facts while studying the behavior of asset prices. One line of progress for solving this shortcoming has been to modify utility to account for habit persistence and to incorporate capital adjustment costs. This paper study a small open economy general equilibrium model along with asset pricing formula based on the lognormality of the disturbance distribution. Our results stipulate that extending models with habit forming preferenses and capital adjustment cost fails to account for a substantial equity premium in a small open economy environment.

• Item Type: MPRA Paper
• Institution: UQAM
• Language: English
• Keywords: Asset pricing, Equity premium, habit formation, small open economy JEL classification: G15, G12, C63, F41
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Abel, A. B., 1980, 'Empirical Investment Equations: An Integrative Framework', Carnegie-Rochester Conference Series on Public Policy 12, 39-91.

Abel, A. B., 1991, 'Asset Prices under Habit Formation and Catching up with the Joneses', NBER Reprints 1661 (also Working Paper 3279 ), National Bureau of Economic Research, Inc.

Allais, O., Cadiou, L., and S. Dées, 2000, 'Consumption Habit and Equity Premium in the G7 Countries' CEPII, document de travail n 2000 -19, December.

Benninga, S., and A., Protopapadakis, 1990, ' Leverage Time Preference, and the Equity Premium Puzzle' Journal of Monetary Economics, 25:49-58.

Black, F., 1990, 'Mean Reversion and Consumption Smoothing', Review of Financial Studies, 3:107-114.

Boldrin, M, L. J. Christiano and J. D. M. Fisher, 1995, ' Asset Pricing Lessons for Modeling Business Cycles,' National Bureau of Economic Research Working Paper 5262.

Boldrin , M, L. J. Christiano and J. D. M. Fisher, 2001, 'Habit Persistence, Asset Returns, and the Business Cycle', American Economic Review 91:149-166.

Budria, S. R, 2003, 'Asset Prices Under Non-Additive Habits', University of Alicante.

Campbell, J. Y., 1986, 'Bond and Stock Returns in Simple Exchange Model', Quarterly Journal of Economics 101:785-804.

Campbell, J. Y., 1993, 'Intertemporal Asset Pricing without Consumption Data', American Economic Review 83:487-512.

Campbell, J. Y., 1996, 'Understanding Risk and Return' Journal of Political Economy, 104:298-345.

Campbell, J. Y., and J. H. Cochrane, 1999, 'By Force of Habit: A consumption-Based Explanation of Aggregate Stock Market Behavior', Journal of Political Economy, 107:205-251.

Campbell, J. Y., 2001, 'Asset Prices, Consumption, and The Business Cycle' Chapter 19 in J. B. Taylor and M. Woodford eds. Handbook of Macroeconomics vol. 1 North Holland, Amsterdam, 1231-1303 (Updated version: Consumption-Based Asset Pricing - Unpublished Paper).

Clinton, K., 1998, 'Canada-U.S. Long Term Interest Differentials in the 1990s', Bank Of Canada Review (Spring): 17-38.

Cochrane, J. H., and L. P. Hansen, 1992, 'Asset Pricing Lessons for Macroeconomics', in O. J. Blanchard and S. Fisher, eds., NBER Macroeconomics Annual 1992, MIT Press, Cambridge.

Constantinides, G., 1990, 'Habit Formation: A Resolution of the Equity Premium Puzzle', Journal of Political Economy, 98:519-543.

Danthine, J. P., J. B. Donaldson and R., Mehra, 1992, ' The Equity Premium and the Allocation of Income Risk', Journal of Economic Dynamics and Control, 17:509-532.

Dib, A., 2003, 'Monetary Policy in Estimated Models of Small Open and Closed Economies' Bank of Canada Working Paper No. 2003-27.

Eisner, R., and R.H., Strotz, 1963, 'Determinants of Business Investment, Impacts of Monetary Policy, Compiled by the Commission on Money and Credit', Englewood Cliffs: Prentice-Hall.

Hansen, L. P., K. J. Singleton, 1983, 'Stochastic Consumption, Risk Aversion and the Temporal Behavior of Asset Returns', Journal of Political Economy, 91:249-265.

Jermann, U. J., 1998, 'Asset Pricing in Production Economies', Journal of Monetary Economics, 41:257-275.

Kandel, S., and R. F., Stambaugh, 1991, 'Asset Returns and Intertemporal Preferences', Journal of Monetary Economics, 27:39-71.

King, R. G., C. I. Plosser and S. T. Rebelo, 1988, 'Production Growth and Business Cycles', Journal of Monetary Economics, 21:195-232, 309-341.

Kocherlakota, N., 1996, 'The Equity Premium: It's Still a Puzzle', Journal of Economic Literature 34:42-71.

LeRoy, S. F., and R. Porter, 1981, 'The Present Value Relation: Tests on Variance Bounds', Econometrica, 49:555-577.

Letendre, M-A., 2003, 'Capital utilization and habit formation in a small-open economy model' Forthcoming in Canadian Journal of Economics.

Lettau, M. and H. Uhlig, 1997, 'Preferences, Consumption Smoothing and Risk Premia', Tilburg University, mimeo, June.

Lucas, R. E., Jr. 1978, 'Asset Prices in an Exchange Economy', Econometrica 46, 1429-1445.

Lucas, R. E., Jr. and E.C. Prescott, 1971, 'Investment under Uncertainty', Econometrica, 39:659-681.

McCallum, B. T., and E. Nelson, 1998, 'Nominal Income Targeting in an Open-Economy Optimizing Market' National Bureau of Economic Research Working Paper 6675.

Mehra, R., and E. C. Prescott, 1985, 'The Equity Premium: A Puzzle', Journal of Monetary Economics, 15:145-161.

Mendoza, E., and Uribe M., 2000, 'Devaluation Risk and the Business-Cycle Implication of Exchange Rate Management', Carnegie Rochester Conference Series on Public Policy 53, 239-96.

Prescott, E. C., 1986, 'Theory Ahead of Business Cycle Measurement', Carnegie-Rochester Conference series on Public Policy, 25:11-66.

Rouwenhorst, G.K., 1995, 'Asset Returns and Business Cycles' in Frontiers of Business Cycle Research, Editor: Thomas F. Cooley, 294-330.

Schmitt-Grohé, S. and M. Uribe, 2003, 'Closing Small Open Economy Models', NBER Working Paper 9270.

Senhadji, A., 1997, 'Sources of Debt Accumulation in a Small Open Economy', International Monetary Fund. Working Paper No. 97/146.

Shiller, R. J., 1981, 'Do Stock Prices Move too much to be Justified by Subsequent Changes in Dividends?', American Economic Review, 71:421-436.

Sundaresan, S. M., 1989, 'Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth', Review of Financial Studies, 2:73-89.

Weil, P., 1989, ' The Equity Premium Puzzle and the Risk-Free Rate Puzzle', Journal of Monetary Economics, 24:401-421.