Inflation risk and default risk in a dynamic general equilibrium asset pricing model for an emerging market economy

Abstract

In this thesis, the difference between the T-Bill returns and common stock returns in Turkey is examined. It is observed that there is a bond premium in Turkey unlike the equity premium observed in developed countries. To understand this surprising observation, inflation-risk and default-risk are incorporated to the Mehra-Presscott (1985) dynamic asset pricing model. Inflation-risk alone is found to be insufficient to explain this bond premium. Only after allowing for a perceived default-risk, the observed bond premium of Turkish T-Bills over Turkish common stocks can be explained by such a model.