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A Model of Monetary Policy and Risk Premia

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  • ITAMAR DRECHSLER
  • ALEXI SAVOV
  • PHILIPP SCHNABL

Abstract

We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk†tolerant agents (banks) borrow from risk†averse agents (i.e., take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a “Greenspan put,†and the yield curve.

Suggested Citation

  • Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2018. "A Model of Monetary Policy and Risk Premia," Journal of Finance, American Finance Association, vol. 73(1), pages 317-373, February.
  • Handle: RePEc:bla:jfinan:v:73:y:2018:i:1:p:317-373
    DOI: 10.1111/jofi.12539
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    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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