International Equity Premia and Rates for Interconnected and Heterogeneous Economies

Abstract

This work studies asset pricing in which 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, the levels of risk aversions and the sensitivity to habit formation. 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 can increase with the level of international growth interdependencies and the levels of heterogeneities. Depending on the structure of international growth interaction, the equity premia can be higher for both pessimistic and optimistic agents. International equity premia are closer to the empirical findings compared to standard models. Further, real exchange rate volatilities are much higher and more persistent compared to the literature and closer to the empirical findings. We developed an international workhorse model, which can explain simultaneously the international interest-rates puzzles, the international equity premium puzzles, the real exchange rate volatility puzzle, and the home bias puzzle, in light of a distinct structural economic analysis.

Keywords: Asset pricing, 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