Forecasting Financial Returns with a Structural Macroeconomic Model

Abstract

This paper investigates the ability of a fully structural macro-finance model to forecast long-term financial returns. We estimate a Dynamic Stochastic General Equilibrium (DSGE) model that describes the dynamics of the U.S. economy. The model includes government bond and stock market returns, which allows us to describe bond and stock risk premia. We first show that these risk premia are fundamentally related to other shocks in the economy. Second, the DSGE model reproduces the mean reversion in the term structure of risks for bond and stock returns. It also generates long-term forecasts of financial returns that outperform unrestricted VAR models.