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Show Me the Money: The Monetary Policy Risk Premium

90 Pages Posted: 27 Mar 2016 Last revised: 24 Oct 2017

Ali K. Ozdagli

Federal Reserve Banks - Federal Reserve Bank of Boston

Mihail Velikov

Federal Reserve Bank of Richmond

Multiple version iconThere are 2 versions of this paper

Date Written: October 23, 2017

Abstract

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

Ozdagli, Ali K. and Velikov, Mihail, Show Me the Money: The Monetary Policy Risk Premium (October 23, 2017). Available at SSRN: https://ssrn.com/abstract=2754812

Ali Ozdagli (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

HOME PAGE: http://sites.google.com/site/ozdagli/

Mihail Velikov

Federal Reserve Bank of Richmond ( email )

502 S. Sharp Street
Baltimore, MD 21201
United States

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