Monetary Policy and Market Volatility
30 Pages Posted: 20 Dec 2018 Last revised: 18 Jan 2020
Date Written: December 12, 2018
An unanticipated tightening of monetary policy increases option implied volatility in equity and bond markets. At the same time, realized volatility declines over the period corresponding to the increase in option implied volatility. The result is a decrease in the volatility swap return, defined as a forward contract on the realized volatility of an underlying asset. This is consistent with an increase in investor risk aversion, or an increase in the willingness to pay for volatility insurance. Subsequent to the contractionary shock, equity returns are positive, while bond returns are negative.
Keywords: monetary policy, shadow short rate, implied volatility, volatility swap
JEL Classification: G1, E5
Suggested Citation: Suggested Citation