PDF Ebook Stock market volatility, federal funds rate surprises and economic factors
The effect of monetary policy on the securities’ markets has been of central importance to investors, policymakers, the financial press and academics. Central bankers have long referred to the effects of monetary policy on financial variables. Analysts and pundits point to the pronounced reaction of the stock market to news regarding monetary policy. Stock markets respond, according to analysts and the financial press, to a multitude of monetary policy-related announcements such as regular meetings of the Federal Open Market Committee (FOMC), wording of FOMC statements, changes in Federal Reserve (Fed) leadership or to changes in the stance and direction of monetary policy.
While the financial press allocates significant resources to the collection and analysis of news related to monetary policy, financial institutions assign analysts (“Fed watchers”) whose role centers on inferring and forecasting the stance of monetary policy. The direction and magnitude of the Fed’s next move or news about changing monetary policy goals or leadership is consequently regarded as essential information to rational investors and is closely monitored by financial institutions and the press. Underlying such attention is an established effect of monetary policy actions on various asset returns.
The academic literature (e.g., Mishkin, 2007) describes the channels through which monetary policy exerts an effect on the stock market as well as the important role that asset markets occupy in the monetary transmission mechanism. In particular, the forward looking nature of stock markets allows for a rapid impact of Fed actions on stock returns and volatilities. We briefly discuss the channels though which monetary policy affects the stock market. First, a change in the federal funds rate is closely associated with changes in various short-term interest rates. This, in turn, influences the discount rate used to value the cash flows of different equities and may thus increase or decrease stock returns and volatility. A second channel through which monetary policy affects the stock market is through financial leverage: each rate change by the Fed changes the cost for firms to finance their activities through issuing debt. Both of these channels can impact stock market returns and volatilities.
The effects of monetary policy changes on financial variables are extensively discussed and documented in the literature. Cook and Hahn (1989), Thornton (1998), Kuttner (2001) and Cochrane and Piazzesi (2002) investigate the effect of monetary policy on interest rates. Thorbecke (1997), Patelis (1997), Goto and Valkanov (2002), D’Amico and Farka (2006), Zebedee et al (2008), Rigobon and Sack (2004) and Bernanke and Kuttner (2005) find that monetary policy surprises lead to a decrease in stock returns. Another line of research (Bomfim, 2003; Chulia, Martens and van Dijk, 2010; Basistha and Kurov, 2008; and Kurov, 2010) uncovers a significant effect of monetary policy on stock market volatility and investor sentiment. In the context of foreign exchange markets, Fatum and Scholnick (2008) find that monetary policy surprises significantly affect exchange rates.
A parallel literature examines the effects of monetary policy on implied stock market volatility. This literature differs from the aforementioned papers by focusing almost entirely on detecting the effects of monetary and macroeconomic policy announcements, rather than examining the effects of monetary policy changes on volatility. That is, the aim of this literature has been to check whether the mere presence of a scheduled or unscheduled announcement significantly impacts volatility, with no regard to the content of the announcement which is unknown a priori. Within this context, Ederington and Lee (1993, 1996), Donders and Vorst (1996), Nikkinen and Salhlstrom 2004), Carr and Wu (2006), Kearney and Lombra (2004) and Chen and Clements (2007) report a significant monetary policy announcement effect.
Download
PDF Ebook Stock market volatility, federal funds rate surprises and economic factors
Posted in :
