The Macroeconomic Shock with the Highest Price of Risk

Abstract

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.