Volatility in Equity Markets and Monetary Policy Rate Uncertainty

34 Pages Posted: 7 Mar 2018

Date Written: December 21, 2017

Abstract

Asset pricing models assume the risk-free rate to be a key factor for equity prices. Hence, there should be a strong link between monetary policy rate uncertainty and equity return volatility, both in theory and data. This paper uses regression-based projections for realized variance to examine the relationship between short horizon forecasts of equity variance and proxies for monetary policy rate uncertainty. By assessing various projection models for UK, US and euro-area equity indices, we show that the proxies for monetary policy rate uncertainty have a significant and positive predictive power for the equity return variance. Adding monetary policy rate uncertainty variables can significantly improve forecasting models for equity variance and volatility at weekly, monthly and even quarterly horizons. The findings imply that market views of short-term interest rate developments may indeed be embedded in equity prices and their variations.

Keywords: Equity indices, monetary policy rate uncertainty, option implied volatility, realized volatility, risk-free interest rates, volatility forecasting

JEL Classification: C22, C52, E52, G12

Suggested Citation

Kaminska, Iryna and Roberts-Sklar, Matt, Volatility in Equity Markets and Monetary Policy Rate Uncertainty (December 21, 2017). Bank of England Working Paper No. 700. Available at SSRN: https://ssrn.com/abstract=3135232

Iryna Kaminska (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Matt Roberts-Sklar

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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