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

The relation between macroeconomic fundamentals and the cross section of asset returns is studied through the lens of dynamic stochastic general equilibrium (DSGE) models. We provide a full-information Bayesian estimation of the model using seven macroeconomic variables and extract the time series of three fundamental shocks to the economy for the period of 1966Q1-2010Q3: neutral technology (NT ) shock, investment-specific technological (IST ) shock, and monetary policy (MP ) shock. Tests based on the General Method of Moments (GMM) show that the factor model with estimated latent shocks as risk factors performs better than and the model-implied pricing kernel performs as well as the Fama-French threefactor models at the 5% significance level in explaining the cross-sectional returns of a large set of assets including the 25 size/BM, 48 industry, and 8 bond portfolios. Our results show that DSGE models, which have been successful in matching macroeconomic dynamics, have great potential in capturing asset price dynamics as well. JEL Classification: G31