Show Me the Money: The Monetary Policy Risk Premium
Within the large strand of macroeconomics literature that studies monetary policy, a substantial subset examines the effects of monetary policy on asset prices. Because the most immediate effects of policy actions are felt in financial markets, understanding the differential responses in the cross-section of equities is crucial for our understanding of the broader impact of monetary policy. While there seems to be a consensus about the fact that monetary policy affects aggregate risk premia, its effects on the cross-section of risk premia are not as well understood. In this paper, the authors address this gap in understanding by developing a monetary policy exposure index at the individual-firm level, which they then use to study how monetary policy affects the cross-section of expected stock returns.
- Stocks whose prices react more positively to expansionary monetary policy surprises earn lower average returns, consistent with the notion that that monetary policy is more likely to be expansionary in tough times, and hence firms with high exposure to monetary policy provide a hedge against bad times.
- A long-short trading strategy designed to exploit this effect achieves an annualized value-weighted return of 9.96 percent, with an associated annualized Sharpe Ratio of 0.93 and a Fama and French five factor alpha of 5.88 percent between 1975 and 2015. This performance is roughly double that of other popular anomalies such as gross profitability or momentum.
Measuring the monetary policy exposure of an individual stock is a difficult identification problem because the idiosyncratic volatility of individual stocks leads to large standard errors of estimates from a direct approach, especially when a stock does not have a long enough history. Instead, in the spirit of the literature on financial constraints and distress, the authors generate a parsimonious monetary policy exposure index based on observable firm characteristics that are likely to drive the exposure of firms to monetary policy. Thus, their approach builds a bridge between the literature that connects firm characteristics to expected returns and the literature that studies macroeconomic aggregates as a predictor of asset returns. While the authors derive their monetary policy exposure index to study its implications for asset pricing, the index can also be useful in future research about the relationship between firms' financing and investment decisions and monetary policy.
We study how monetary policy affects the cross-section of expected stock returns. For this purpose, we create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that are theoretically linked to how firms react to monetary policy. We find that stocks whose prices react more positively to expansionary monetary policy surprises earn lower average returns. This finding is consistent with the intuition that monetary policy is expansionary in bad economic times when the marginal value of wealth is high, and thus high MPE stocks serve as a hedge against bad times. A long-short trading strategy designed to exploit this effect achieves an annualized value-weighted return of 9.96 percent with an associated Sharpe Ratio of 0.93 between 1975 and 2015. This return premium cannot be explained by standard factor models and survives a battery of robustness tests.