Fed Put in the Equity Options Markets

Abstract

We look at the effects of monetary policy on the stock market and market participants' expectations through the lens of the equity option market. Options permit us to distinguish the effect of monetary policy on the cost of capital from its effect on market expectations about the future payoffs to equity investors. Given the difficulties in identifying monetary policy stance, we use several distinct approaches, such as natural language processing of FOMC minutes, regime switching models, and deviations from Taylor Rule. We address reverse causality using conventional instrumental variables method as well as causal forest based methods. We find that, with loose Fed monetary policy, traded equity put (call) options are significantly cheaper (more expensive) versus with tight monetary policy. We interpret this as a manifestation of the ``Fed Put". Accommodative monetary policy also creates a moral hazard as out of the money call options exhibit higher prices. We find some evidence that the effect of Fed policy on option prices reflects an expectation that the Fed will support the stock market even beyond the extent to which the real economy may need support.

Keywords: Fed Funds Rate, Implied Volatility, Volatility Skew Surface, Greenspan Put.

JEL Classification: E44, E528, G13, G28