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Another Look at the Stock Return Response to Monetary Policy Actions

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  • Paulo Maio

Abstract

I analyze the effect of monetary policy actions on the cross-section of equity returns. Based on earlier theoretical work for the monetary transmission mechanism one can argue that changes in monetary policy should produce differentiated effects on firms and stocks with different characteristics. By using different portfolio sorts the results show that the impact of monthly changes in the Federal funds rate is greater for the returns of more financially constrained stocks (e.g., small and value stocks) than on the returns of stocks with a more favorable financial position (e.g., large and growth stocks). By using a VAR methodology, the results indicate that the negative effect of Fed funds rate shocks on stock returns comes from a corresponding negative effect on future expected cash flows (cash-flow news), which is stronger than the impact on future equity risk premia (discount rate news). Thus, cash-flow news is the main return component affected by changes in the Fed funds rate. These results are reasonably robust to different VAR specifications. Moreover, the dispersion in return responses to monetary shocks across stocks is explained by a similar dispersion in the effects into cash-flow news, which outweighs the dispersion in discount rate news betas. These results represent new evidence on the effect of monetary policy on stock prices and on the monetary transmission mechanism.

Suggested Citation

  • Paulo Maio, 2014. "Another Look at the Stock Return Response to Monetary Policy Actions," Review of Finance, European Finance Association, vol. 18(1), pages 321-371.
  • Handle: RePEc:oup:revfin:v:18:y:2014:i:1:p:321-371.
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