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Market Pricing of Economic Risks and Stock Returns

We estimate the market prices of economic risks from the stock market, while overcoming the challenges faced by existing studies. First, we use two dynamic factors, one real and the other nominal, to summarize the systematic information and to suppress the noise in a large array of economic indicators. Second, in linking systematic economic risks to stock returns, we carefully separate the cash flow effect from the pricing kernel effect. We first estimate the economic risk exposures for each individual stock, and then investigate how the expected return on each stock varies with its economic risk exposures. The different risk exposure estimates for different stocks capture the cash flow effect. How the expected stock return varies with the economic risk exposure reveals how the market prices the economic risks. Our estimation shows that the market charges a positive price for the real output growth risk, but a negative price for the inflation risk.