Monetary Policy and Risk-Based Asset Allocation
23 Pages Posted: 29 Mar 2016 Last revised: 19 Apr 2016
Date Written: June 1, 2015
This paper focuses on the effects of the Fed’s monetary policy on stock and bond returns co-movement and their implications to risk-based asset allocation. Using a regime-switching model that controls for the economic effects of monetary policy we identify three co-movement regimes. We document that risk-based portfolio strategies poorly perform in the low correlation regime which features inflation shocks. We find outperformance evidence under the negative correlation regime with a high stock market risk and a very accommodating Fed policy. Less effectiveness is demonstrated under the positive correlation regime where bonds are regarded as risky assets and interest rate volatility is fueled by monetary policy.
Keywords: Monetary policy, Hidden Markov Model, Co-movement, Minimum variance, Equal risk contribution
JEL Classification: E22, E58, G11, G17
Suggested Citation: Suggested Citation