Federal Reserve Bank of Boston
Show me the money: the monetary policy risk premium
We study how monetary policy affects the cross-section of expected stock returns. For this purpose, we create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that are theoretically linked to how firms react to monetary policy. We find that stocks whose prices react more positively to expansionary monetary policy surprises earn lower average returns. This finding is consistent with the intuition that monetary policy is expansionary in bad economic times when the marginal value of wealth is high, and thus high MPE stocks serve as a hedge against bad times. A long-short trading strategy designed to exploit this effect achieves an annualized value-weighted return of 9.96 percent with an associated Sharpe Ratio of 0.93 between 1975 and 2015. This return premium cannot be explained by standard factor models and survives a battery of robustness tests.
Cite this item
Ali K. Ozdagli & Mihail Velikov, Show me the money: the monetary policy risk premium, Federal Reserve Bank of Boston, Working Papers 16-27, 01 Dec 2016.
- E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
- E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
Keywords: monetary policy; asset pricing; risk factors
This item with handle RePEc:fip:fedbwp:16-27
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