Risk aversion decomposition and the impact of monetary policy surprises on aggregate tail risk aversion

Purpose - The purpose of this paper is to present theoretical and empirical support that the fear component associated with rare events has an impact on risk premium and market returns. Design/methodology/approach - Extension of jump-diffusion model to extract the fear component from representative agent risk aversion, Standard VAR and impulse response function analysis, Event study analysis. Findings - The model implicates that investor fear of tail jumps in the financial market impacts equity risk premium. The empirical findings show both positive stock and monetary policy shocks decrease investor’s fear. It can be attributed to that a bullish stock market and an increase in interest rate reflects expanding economy, and it leads to a decrease in fear. Moreover, a surprise decline in the expected short-term rate has a mixed impact on tail risk aversion. A plausible explanation is that investors believe a surprise drop in an expected short-term rate reflects a fast deteriorating economic outlook during unconventional monetary policy period. Originality/value - This paper provides theoretical framework to decompose risk aversion into two separate components: one component associated with daily volatility, and the fear component associated with rare events. The study uses risk premiums decomposed from Chicago Board Options Exchange volatility index as proxies for the two components of risk aversion, and then utilizes standard value at risk and event study analysis to show the fear component plays a role in risk premium and market return.