The macroeconomic shock with the highest price of risk

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 23 September 2016

Working Paper No. 616
By Gabor Pinter 

I propose a new method of constructing a macroeconomic shock based on its ability to explain the cross-section of asset returns. The only identifying assumption is that this λ-shock demands the highest risk price per unit of exposure, or equivalently, minimises the associated sum of squared pricing errors, when pricing a given asset portfolio. When applying the method to the stock portfolios studied by Fama-French, a robust economic feature of the λ-shock is the delayed effect on aggregate quantities such as output and consumption and a sharp impact on the short-term interest rate and the term spread. The estimated λ-shock bears strong resemblance both with monetary policy shocks and with technology news shocks studied by the macroeconomic literature.

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