Don't Fight the Fed!

Review of Finance, Forthcoming

72 Pages Posted: 11 Mar 2012 Last revised: 22 Dec 2012

See all articles by Paulo F. Maio

Paulo F. Maio

Hanken School of Economics - Department of Finance and Statistics

Date Written: December 21, 2012

Abstract

Monetary policy, as captured by changes in the Fed funds rate (FFR), is a useful signal for investors. I analyze the economic significance of trading strategies based on the “out-of-sample” forecasting power of FFR for excess equity returns. A simple market timing strategy produces an annual Sharpe ratio of 0.55 and a certainty equivalent return (CER) gain of 3.37% per year, whereas a buy-hold strategy has a Sharpe ratio of 0.41. Rotation trading strategies for portfolios sorted on size, book-to-market, and momentum have a Sharpe ratio and CER gain as high as 0.73 and 9.60% per year, respectively. Dynamic strategies for other asset classes also produce economically significant gains. Generally, the strategies based on FFR outperform those associated with alternative predictors.

Keywords: asset pricing, predictability of stock returns, monetary policy and stock returns, out-of-sample predictability, economic significance of predictability, Federal Funds rate, stock rotation strategies, market-timing strategies, asset allocation, portfolio choice, size, value and momentum anomalies

JEL Classification: E44, G11, G12, G17

Suggested Citation

Maio, Paulo F., Don't Fight the Fed! (December 21, 2012). Review of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2019954 or http://dx.doi.org/10.2139/ssrn.2019954

Paulo F. Maio (Contact Author)

Hanken School of Economics - Department of Finance and Statistics ( email )

FI-00101 Helsinki
Finland

HOME PAGE: http://sites.google.com/site/paulofmaio/home

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