In 2013 all ECB publications feature a motif taken from the €5 banknote.note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. ABSTRACTThe VIX, the stock market option-based implied volatility, strongly co-moves with measures of the monetary policy stance. When decomposing the VIX into two components, a proxy for risk aversion and expected stock market volatility ("uncertainty"), we find that a lax monetary policy decreases both risk aversion and uncertainty, with the former effect being stronger. The result holds in a structural vector autoregressive framework, controlling for business cycle movements and using a variety of identification schemes for the vector autoregression in general and monetary policy shocks in particular. The effect of monetary policy on risk aversion is also apparent in regressions using high frequency data. JEL Codes:E44, E52, G12, G20, E32 Keywords:Monetary policy, option implied volatility, risk aversion, uncertainty, business cycle 2 NON-TECHNICAL SUMMARYA popular indicator of risk aversion in financial markets, the VIX index, strongly co-moves with measures of the monetary policy stance in the United States. While the current VIX is positively associated with future (real) Fed funds rates, the relationship turns negative and significant after 13 months: high VIX readings are correlated with expansionary monetary policy in the mediumrun future (see Figure 1).The strong interaction between the VIX index, known as a "fear index" (Whaley (2000) (2005) ascribe the bulk of the effect to easier monetary policy lowering risk premiums, reflecting both a reduction in economic and financial volatility and an increase in the capacity of financial investors to bear risk. By using the VIX and its two components, we test the effect of monetary policy on stock market risk, but also provide more precise information on the exact channel.This article characterizes the dynamic links between risk aversion, uncertainty and monetary policy in a structural vector autoregressive (VAR) framework. Our VARs always include a business cycle indicator to control for business cycle movements. The main findings are as 3 follows. A lax monetary policy decreases risk aversion in the stock market after about nine months. This effect is persistent, lasting for more than two years. Moreover, monetary policy shocks account for a significant proportion of the variance of the risk aversion proxy. Monetary policy shocks have a significant impact on risk aversion also in regressions using high frequency data. The effects of monetary policy on uncertainty are similar but somewhat weaker.On the other hand, periods of both high uncertainty and high risk aversion are followed by a looser monetary policy stance but these results are less robust and weaker statistically. Finally, it is the uncertainty component of the VIX that has the statistically stronger effect on the business cyc...

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Information on all of the papers published in the ECB Working Paper Series can be found on the ECB's website, http://www.ecb.europa.eu/pub/scientific/wps/date/html/index.en.html Terms of use: Documents in EconStor may AcknowledgementsWe thank the Editor, Alok Bhargava, and three anonymous reviewers for useful comments and suggestions that improved the paper. Carlos Garcia de Andoain provided excellent research assistance. Geert Bekaert acknowledges financial support from Netspar. The views expressed do not necessarily reflect those of the European Central Bank or the Eurosystem. Geert Bekaert Columbia UniversityMarie Hoerova (corresponding author) European Central Bank; e-mail: marie.hoerova@ecb.europa.eu 1 AbstractWe decompose the squared VIX index, derived from US S&P500 options prices, into the conditional variance of stock returns and the equity variance premium. We evaluate a plethora of state-of-the-art volatility forecasting models to produce an accurate measure of the conditional variance. We then examine the predictive power of the VIX and its two components for stock market returns, economic activity and financial instability. The variance premium predicts stock returns while the conditional stock market variance predicts economic activity and has a relatively higher predictive power for financial instability than does the variance premium. JEL Classification: C22, C52, G12, E32Keywords: option implied volatility; realized volatility; VIX; variance risk premium; risk aversion; stock return predictability; risk-return trade-off; economic uncertainty; financial instability. How to measure the variance premium is not without controversy however, because it relies on an estimate of the conditional variance of stock returns. In this article, we tackle several measurement issues for the variance premium, assessing a plethora of state-of-the-art volatility models and making full use of overlapping daily data, rather than sparse end-of-month data, which is standard.The conditional variance measure is of interest in its own right. uses the VIX index to measure uncertainty, so that his results may actually be driven by the variance premium rather than uncertainty per se.Using more plausible estimates of the variance premium and stock market volatility, we then assess whether they predict stock returns, economic activity, as well as financial instability, an economic outcome that has garnered considerable policy interest in the aftermath of the recent fin...

In 2013 all ECB publications feature a motif taken from the €5 banknote.note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. ABSTRACTThe VIX, the stock market option-based implied volatility, strongly co-moves with measures of the monetary policy stance. When decomposing the VIX into two components, a proxy for risk aversion and expected stock market volatility ("uncertainty"), we find that a lax monetary policy decreases both risk aversion and uncertainty, with the former effect being stronger. The result holds in a structural vector autoregressive framework, controlling for business cycle movements and using a variety of identification schemes for the vector autoregression in general and monetary policy shocks in particular. The effect of monetary policy on risk aversion is also apparent in regressions using high frequency data. JEL Codes:E44, E52, G12, G20, E32 Keywords:Monetary policy, option implied volatility, risk aversion, uncertainty, business cycle 2 NON-TECHNICAL SUMMARYA popular indicator of risk aversion in financial markets, the VIX index, strongly co-moves with measures of the monetary policy stance in the United States. While the current VIX is positively associated with future (real) Fed funds rates, the relationship turns negative and significant after 13 months: high VIX readings are correlated with expansionary monetary policy in the mediumrun future (see Figure 1).The strong interaction between the VIX index, known as a "fear index" (Whaley (2000) (2005) ascribe the bulk of the effect to easier monetary policy lowering risk premiums, reflecting both a reduction in economic and financial volatility and an increase in the capacity of financial investors to bear risk. By using the VIX and its two components, we test the effect of monetary policy on stock market risk, but also provide more precise information on the exact channel.This article characterizes the dynamic links between risk aversion, uncertainty and monetary policy in a structural vector autoregressive (VAR) framework. Our VARs always include a business cycle indicator to control for business cycle movements. The main findings are as 3 follows. A lax monetary policy decreases risk aversion in the stock market after about nine months. This effect is persistent, lasting for more than two years. Moreover, monetary policy shocks account for a significant proportion of the variance of the risk aversion proxy. Monetary policy shocks have a significant impact on risk aversion also in regressions using high frequency data. The effects of monetary policy on uncertainty are similar but somewhat weaker.On the other hand, periods of both high uncertainty and high risk aversion are followed by a looser monetary policy stance but these results are less robust and weaker statistically. Finally, it is the uncertainty component of the VIX that has the statistically stronger effect on the business cyc...

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