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

Authors: Lii-Tarn Chen, C. James Hueng, Chien-fu Jeff Lin

Addresses: Academia Sinica, Taiwan. ' University of Alabama, USA. ' National Taiwan University, Taiwan

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.

Keywords: bubbles; time-varying risk premiums; stock prices; Kalman filter; state-space model; misspecification; market prices.

DOI: 10.1504/GBER.2000.006157

Global Business and Economics Review, 2000 Vol.2 No.2, pp.159 - 171

Published online: 07 Feb 2005 *

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