The Peso problem hypothesis and stock market returns

The Peso problem hypothesis has often been advocated in the financial literature to explain the historically puzzlingly high risk premium of stock returns. Using a dynamic model of learning, this paper shows that the implications of the Peso problem hypothesis are much more far reaching than the ones commonly advocated, implying most of the stylized facts about stock returns. These include high risk premia, time-varying volatility, asymmetric volatility reaction to good and bad news, excess sensitivity of price reaction to dividend changes and thus excess return volatility. (C) 2003 Elsevier B.V. All rights reserved.