Monetary Policy Shocks and Variance Risk Premia
38 Pages Posted: 20 Dec 2018 Last revised: 11 Jan 2019
Date Written: December 12, 2018
This paper asks how monetary policy shocks impact variance risk premia, and thus investor risk aversion, across bond and equity markets. I document the following results: First, contractionary monetary policy shocks increase variance risk premia in bond and equity markets. This implies an overall increase in investor risk aversion. Second, the increase in variance risk premia is driven primarily by an increase in option implied volatility, while realized volatility is relatively less affected. Thus, there is a substantial increase in the price of risk, but little increase in actual risk. Third, bond markets experience a positive return following a contractionary shock, while equity markets experience a negative return. This occurs because higher levels of risk aversion increase the attractiveness of safe assets, relative to riskier assets.
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