Macroeconomic Risks and Asset Pricing: Evidence from a Dynamic Stochastic General Equilibrium Model

Abstract

We study the relation between macroeconomic fundamentals and asset pricing through the lens of a dynamic stochastic general equilibrium (DSGE) model. We provide full-information Bayesian estimation of the DSGE model using macroeconomic variables and extract the time-series of four latent fundamental shocks of the model: neutral technology shock, investment-specific technological shock, monetary policy shock, and risk shock. Asset pricing tests show that our model-implied four-factor model can explain a number of prominent cross-sectional return spreads: size, book-to-market, investment, earnings, and long-term reversal. The investment-specific technological shock and risk shock play the most important role in explaining those return spreads.

Keywords: DSGE model, Bayesian MCMC estimation, stock returns, neutral technology shock, investment-specific technology shock, monetary policy shock, risk shock

JEL Classification: C11, C13, E44