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Estimating the Expected Marginal Rate of Substitution: Exploiting Idiosyncratic Risk

  • Robert P. Flood
  • Andrew K. Rose

This paper develops a simple but general methodology to estimate the expected intertemporal marginal rate of substitution or "EMRS", using only data on asset prices and returns. Our empirical strategy is general, and allows the EMRS to vary arbitrarily over time. A novel feature of our technique is that it relies upon exploiting idiosyncratic risk, since theory dictates that idiosyncratic shocks earn the EMRS. We apply our methodology to two different data sets: monthly data from 1994 through 2003, and daily data for 2003. Both data sets include assets from three different markets: the New York Stock Exchange, the NASDAQ, and the Toronto Stock Exchange. For both monthly and daily frequencies, we find plausible estimates of EMRS with considerable precision and time-series volatility. We then use these estimates to test for asset integration, both within and between stock markets. We find that all three markets seem to be internally integrated in the sense that different assets traded on a given market share the same EMRS. The technique is also powerful enough to reject integration between the three stock markets, and between stock and money markets.

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File URL: http://www.nber.org/papers/w10805.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10805.

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Date of creation: Oct 2004
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Publication status: published as Flood, Robert and Andrew Rose. “Estimating the Expected Marginal Rate of Substitution: A Systematic Exploitation of Idiosyncratic Risk.” Journal of Monetary Economics 2005.
Handle: RePEc:nbr:nberwo:10805
Note: IFM AP
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  1. Robert P. Flood & Andrew K. Rose, 2005. "Financial Integration: A New Methodology And An Illustration," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1349-1359, December.
  2. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  4. Robert G. King & Sergio T. Rebelo, 2000. "Resuscitating Real Business Cycles," NBER Working Papers 7534, National Bureau of Economic Research, Inc.
  5. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
  6. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  7. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 35(5), pages 1073-1103, December.
  8. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
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