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Do bubbles and time-varying risk premiums affect stock prices? a Kalman filter approach

Author

Listed:
  • Lii-Tarn Chen
  • C. James Hueng
  • Chien-fu Jeff Lin

Abstract

This paper separates the validity of the specification of the fundamental stock price model from the implications of bubbles. The time-varying risk premium model (Poterba and Summers, 1986) is used to explicitly derive the misspecification component. We construct a state-space model and use Kalman filter to estimate the relationships between the observable price/dividend and the unobservable bubbles/misspecification. The model is applied to CRSP and S&P 500 data. The results show that the fundamental price model does not describe the market prices well. The time-varying risk premium is important in explaining stock price movements. No significant evidence of bubbles is found.

Suggested Citation

  • Lii-Tarn Chen & C. James Hueng & Chien-fu Jeff Lin, 2000. "Do bubbles and time-varying risk premiums affect stock prices? a Kalman filter approach," Global Business and Economics Review, Inderscience Enterprises Ltd, vol. 2(2), pages 159-171.
    • Handle: RePEc:ids:gbusec:v:2:y:2000:i:2:p:159-171
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