With Tarek A. Hassan and Thomas M. Mertens. Draft coming soon.
Abstract: Canonical long-run risk and habit models address the equity premium puzzle by inducing a strong, negative correlation between the variance and the mean of the stochastic discount factor. When applied to an open economy with complete markets, this key feature requires that differences in currency returns should arise primarily from predictable appreciations, a requirement that is at odds with the data. We term this tension between a high equity premium, smooth risk-free rates, and largely unpredictable exchange rates the currency premium puzzle and argue it is the underlying reason why existing international asset pricing models have struggled to simultaneously match data on currency returns, equity returns, and risk-free rates.