69 Pages Posted: 27 Mar 2016 Last revised: 23 Nov 2016
Date Written: November 23, 2016
This paper studies the effect of monetary policy on the cross-section of expected stock returns. We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that are theoretically linked to how stocks react to monetary policy. We find that stocks whose prices react more positively to expansionary monetary policy surprises, high-MPE stocks, earn lower average returns. This finding is consistent with the intuition that monetary policy is expansionary in times of poor economic conditions when the marginal value of wealth is high, and thus high-MPE stocks serve as a hedge against such periods. A long-short trading strategy designed to exploit this effect achieves an annualized value-weighted return of 9.96% with an associated Sharpe Ratio of 0.93. This return premium cannot be explained by standard factor models and survives a battery of robustness tests.
Keywords: Monetary Policy, Asset Pricing, Risk Factors
JEL Classification: E12, E31, E44, E52, G12, G14
Suggested Citation: Suggested Citation
Ozdagli, Ali K. and Velikov, Mihail, Show Me the Money: The Monetary Policy Risk Premium (November 23, 2016). Available at SSRN: https://ssrn.com/abstract=2754812