Show Me the Money: The Monetary Policy Risk Premium
90 Pages Posted: 27 Mar 2016 Last revised: 24 Oct 2017
Date Written: October 23, 2017
This paper studies the extent to which investors consider monetary policy a source of risk, using evidence from cross-sectional stock returns. We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that have been linked to how stocks react to monetary policy in the previous literature. We find that stocks whose prices react more positively to expansionary monetary policy, high-MPE stocks, earn lower average returns. This finding is consistent with the fact that the Federal Reserve eases monetary policy in times of poor economic conditions when the marginal value of wealth is high. 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.
Keywords: Monetary Policy, Asset Pricing, Risk Factors
JEL Classification: E12, E31, E44, E52, G12, G14
Suggested Citation: Suggested Citation