Estimating the expected marginal rate of substitution: A systematic exploitation of idiosyncratic risk

We develop a methodology to estimate the shadow risk free rate or expected intertemporal marginal rate of substitution, ‘‘EMRS’’. Our technique relies upon exploiting idiosyncratic risk, since theory dictates that idiosyncratic shocks earn the EMRS. We apply our methodology to recent monthly and daily data sets for the New York and Toronto Stock Exchanges. We estimate EMRS with precision and considerable time-series volatility, subject to an identification assumption. Both markets seem to be internally integrated; different assets traded on a given market share the same EMRS. We reject integration between the stock markets, and between stock and money markets.