CFA Institute Journal Review summarizes "Show Me the Money: The Monetary Policy Risk Premium," by Ali Ozdagli and Mihail Velikov, published in the Journal of Financial Economics, Vol. 135, No. 2 (February 2020).
Stocks that outperform on the back of expansionary monetary policy surprises provide lower risk premiums and have earned lower overall average returns. This dynamic aligns with the tendency of central banks to support an economy after a negative shock, and firms with higher monetary policy exposure create an effective hedge.
What Is the Investment Issue?
It is well understood that monetary policy has a significant impact on the stock market, and firms with different characteristics are affected by changes in monetary policy to varying degrees. Less well understood is the effect of monetary policy on the cross-section of equity risk premiums. The authors seek to uncover any differences in risk premiums and historical average returns between high and low monetary policy exposure (MPE) stocks.
How Did the Authors Conduct This Research?
The authors create an index of high-MPE stocks. To do this, they interrelate policy surprises with five observable firm characteristics:
- financial constraints
- cash and short-term investments
- cash flow duration
- cash flow volatility
- operating profitability
In past research, these firm characteristics have been connected to monetary policy transmission mechanisms and stock price monetary policy sensitivity. They focus on the following monetary policy transmission mechanisms:
- the credit channel
- the liquidity effect
- the discount rate effect
- nominal rigidities
The authors estimate stock return regression that originates from interest rate futures on Federal Open Market Committee (FOMC) meeting dates. The authors focus on the 116 scheduled FOMC meetings between February 1994 and June 2008. Despite the fact that policy surprises cannot be calculated before 1994 due to the vagueness in the timing of policy decisions, their MPE index computes exposures because firm characteristics are available. The sample is ended in mid-2008, when the zero lower bound becomes a constraint for the federal funds target rate. One important caveat of using only FOMC meetings is that news about monetary policy emerges between meetings via speeches and testimonies by committee members.
Compustat data are used for firm level variables. Following the previous literature, financials and utilities are omitted.
The authors perform a series of checks on their results. Their MPE portfolio maintains its predictability after controlling for other common predictors. Notably, their outcomes seem independent of the pre-FOMC announcement drift or the “betting against beta” effect.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors study assumptions related to the “driver” and “stabilizer” effects of monetary policy to determine if the risk premium is positive or negative.
The authors find that stocks that respond negatively to an expansionary monetary policy surprise average higher returns than stocks that respond positively to the same type of event. The fact that the authors’ high-MPE index is a strong negative predictor of relative average returns suggests that the stabilizer channel has a bigger impact on equity risk premiums than the driver channel.
A long–short trading strategy structured to capitalize on this effect earns an annualized value-weighted return of 9.12% from 1975 to 2015. The t-statistic amounts to 4.91, and the annualized Sharpe ratio is 0.77. Although existing models such as the Fama–French five-factor model reflect some of the excess return, the strategy earns strongly positive abnormal returns even after controlling for these. Moreover, the authors find that they have higher returns for their low-minus-high MPE portfolio after positive CPI and employment surprises. This result provides additional proof of the strength of the stabilizer channel.
The authors’ main conclusion is that stocks show lower average returns when they benefit from expansionary monetary policy surprises. Because central banks tend to extend economic support after a negative shock, it makes sense that firms with higher monetary policy exposure offer an effective hedge.