International Equity Premia and Rates in Heterogeneous Economies

Abstract:     
This paper studies asset pricing wherein the model combines dynamic learning and heterogeneous habit formations with agents' heterogeneous beliefs and preferences in a continuous-time, general-equilibrium and international endowment economy. The intertemporal and frictionless equilibrium model considers two groups of agents who have heterogeneous expectations about the future economic growth of two/N international goods and incomplete information. Additionally, the agents differ in both, with respect to the subjective rate of time preference and in the levels of risk aversions. Further, the agents can have different risk aversions and different external habit formations across goods. The fundamental dynamics of the economies are modeled with interaction across evolutions. The model provides closed-form solutions for all relevant equilibrium quantities. This includes also analytical solutions for asset pricing and asset allocation. With this approach we can perform a qualitative study of agents' heterogeneities and their implications on equilibrium co movements as well as on cross-sectional asset returns within international financial markets. It is shown that the right combination of heterogeneities and learning agents matters and improves the current literature on asset pricing puzzles. The levels of the locally risk-free interest rates and the interest rates volatilities are close to the empirical findings for reasonable model parameters. The international equity premium increases with the level international growth interdependencies and the levels of international heterogeneity, and are also close to the empirical findings. Further, real exchange rate volatilities are much higher and more persistent compare to the literature and closer to the empirical findings. We developed an international workhorse model, which can explain simultaneously the international interest-rates puzzles, international equity premium puzzles, the real exchange rate volatility puzzle, and the home bias puzzle; in the light of a distinct structural economic analysis.

Number of Pages in PDF File: 112

Keywords: Lucas orchard, heterogeneous beliefs and preferences, learning, habit formation, international equity premium puzzle, risk-free rate puzzle, real exchange rate puzzle

JEL Classification: C60, D50, D80, G11, G12, G13

working papers series