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Show me the money: the monetary policy risk premium

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  • Ozdagli, Ali K.

    () (Federal Reserve Bank of Boston)

  • Velikov, Mihail

    () (Federal Reserve Bank of Richmond)

Abstract

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.

Suggested Citation

  • Ozdagli, Ali K. & Velikov, Mihail, 2016. "Show me the money: the monetary policy risk premium," Working Papers 16-27, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:16-27
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    References listed on IDEAS

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    6. Kuttner, Kenneth N., 2001. "Monetary policy surprises and interest rates: Evidence from the Fed funds futures market," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 523-544, June.
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    Cited by:

    1. Pintor, Gabor, 2016. "The macroeconomic shock with the highest price of risk," LSE Research Online Documents on Economics 86225, London School of Economics and Political Science, LSE Library.
    2. Gabor Pinter, 2018. "Macroeconomic Shocks and Risk Premia," Discussion Papers 1812, Centre for Macroeconomics (CFM).
    3. Michael Weber & Andreas Neuhierl, 2016. "Monetary Policy and the Stock Market: Time-Series Evidence," Working Papers 2016-26, Becker Friedman Institute for Research In Economics.

    More about this item

    Keywords

    monetary policy; asset pricing; risk factors;

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
    • 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

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