Erica X. N. Li, Haitao Li, Shujing Wang, Cindy Yu

“Management Science” Vol. 65, No. 8, August 2019, pp. 3585–3604

Recommend reason

This paper studies the link between macroeconomic fundamentals and asset pricing through the lens of a New Keynesian Dynamic Stochastic General

Equilibrium (DSGE) model. Most estimations in the literature essentially match

the unconditional moments of the macroeconomic variables, this research considers the full-information Bayesian Markov chain Monte Carlo (MCMC) method that fully exploits the conditional information in the likelihood function of the macroeconomic data. As a result, the method used in this paper not only provides more efficient estimation of model parameters, but also makes it possible to back out the four latent economic shocks: neutral technology (NT) shock, investment-specific technological (IST) shock, monetary policy (MP) shock, and risk (Risk) shock.

About the author

Erica X. N. Li， Department of Finance, Cheung Kong Graduate School of Business

Haitao Li， Department of Finance, Cheung Kong Graduate School of Business

Shujing Wang，Department of Economics and Finance, School of Economics and Management, Tongji University, Distinguished Associate Research Fellow. The main research directions are asset pricing, China financial market.

Cindy Yu， Department of Statistics, Iowa State University

Keywords

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

Brief introduction

One of the key issues in asset pricing is to understand the economic fundamentals that drive the fluctuations of asset prices. Modern finance theories on asset pricing, however, have mainly focused on the relative pricing of different financial securities. Researchers have been paying increasing attention in relating asset prices to economic fundamentals as evidenced by the rapid growth of the macrofinance literature. The New Keynesian DSGE models offer a unified framework to examine the link between asset prices and economic fundamentals. This paper studies the link between macroeconomic fundamentals and asset pricing through the lens of a New Keynesian DSGE model.

The authors estimate a DSGE model based on nine macroeconomic variables—per capita output growth, per capita consumption growth, per capita investment growth, average weekly hours per capita, growth rate of relative price of consumption to investment goods, inflation, three-month Treasury-bill (T-bill) rate, growth rate of credit supply, and credit spread between BAA corporate bonds and 10-year Treasury bonds—and extract the time series of four latent fundamental shocks. 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—but not the momentum spread. Among the four shocks, the IST and Risk shocks play the most important role in explaining those return spreads.