Show me the money: The monetary policy risk premium |
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| Institution: | 1. Federal Reserve Bank of Boston, 600 Atlantic Avenue, Boston, MA 02210, United States;2. Federal Reserve Bank of Richmond, 502 S Sharp St, Baltimore, MD 21201, United States;1. ESMT European School of Management and Technology, Schlossplatz 1, 10178 Berlin, Germany;2. Frankfurt School of Finance & Management, Adickesallee 32-34. 60322 Frankfurt, Germany;3. Department of Finance, Copenhagen Business School, Solbjerg Plads 3, DK-2000 Frederiksberg, Denmark;4. Danish Finance Institute, DK-2000 Frederiksberg, Denmark;1. Central Bank of Chile, Santiago 8340454, Chile;2. Smeal College of Business, Pennsylvania State University, University Park, PA 16802, USA;3. Instituto de Econom?a, Pontificia Universidad Católica de Chile, Santiago 7820436, Chile;4. Pompeu Fabra University, Barcelona 08005, Spain;1. University of Notre Dame, Notre Dame, IN, USA;2. Booth School of Business, University of Chicago, Chicago, IL, USA;3. NBER USA |
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| Abstract: | We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that previous studies link to how stocks react to monetary policy. Our index successfully captures stocks’ responses to both conventional and unconventional monetary policy. Stocks whose prices react more positively to expansionary monetary policy (high-MPE stocks) earn lower average returns. This result is consistent with the notion that high-MPE stocks provide a hedge against bad economic shocks, to which the Federal Reserve responds with expansionary monetary policy. A long-short trading strategy designed to exploit this effect achieves an annualized Sharpe Ratio of 0.77. |
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