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The Market Price of Risk and Macro-Financial Dynamics

Author

Listed:
  • Adrian, Tobias
  • Duarte, Fernando
  • Iyer, Tara

Abstract

We propose the log conditional volatility of GDP spanned by financial factors as "Volatility Financial Conditions Index" (VFCI) and derive conditions under which it is the log market price of risk. The VFCI exhibits superior explanatory power for stock and bond risk premia compared to other FCIs. We use a variety of identification strategies and instruments to demonstrate robust causal relationships between the VFCI and macroeconomic aggregates: a tightening of the VFCI leads to a persistent contraction of output and triggers an immediate easing of monetary policy. Conversely, contractionary monetary policy shocks cause tighter financial conditions.

Suggested Citation

  • Adrian, Tobias & Duarte, Fernando & Iyer, Tara, 2023. "The Market Price of Risk and Macro-Financial Dynamics," CEPR Discussion Papers 17777, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:17777
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    More about this item

    JEL classification:

    • 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

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