Interest Rate Risk and the Cross Section of Stock Returns

Abstract

We derive a macroeconomic asset pricing model in which the key factor is the opportunity cost of money. The model explains well the cross section of stock returns in addition to the excess market return. The interest rate factor is priced and seems to drive most of the explanatory power of the model. In this model, both value stocks and past long-term losers enjoy higher average (excess) returns because they have higher interest rate risk than growth/past winner stocks. The model significantly outperforms the nested models (capital asset pricing model (CAPM) and consumption CAPM (CCAPM)) and compares favorably with alternative macroeconomic models.

On Monetary Policy and Stock Market Anomalies

“…Lioui and Maio () report similar evidence on the interest rate factor loadings of long‐term reversal quintile portfolio returns. In particular, they find that the losers–winners spread return has a negative interest rate factor loading in 4 out of 5 size quintiles.…”

The Epstein–Zin Model with Liquidity Extension

“…where α is between 0 and 1 and 1 δ denotes the elasticity of substitution between consumption and liquidity. The preference as in Equation (B-2) is the same as those used in Yogo (2006), Gu and Huang (2013), and Lioui and Maio (2014) except that the intraperiod utility here is defined over combinations of consumption and liquidity. 22…”

“…The intraperiod utility inYogo (2006) is defined over nondurable and services consumption and durable consumption. The intraperiod utility inGu and Huang (2013) andLioui and Maio (2014) is defined over nondurable and services consumption and money.…”

Monetary Policy Surprises, Investment Opportunities, and Asset Prices

“…Changes in these futures prices on days of FOMC announcements provide a precise measure of shocks to monetary policy because the futures market incorporates current observable and backward-looking macroeconomic conditions that do not vary much at the daily frequency (e.g., Kuttner 2001;Cochrane and Piazzesi 2002;Bernanke and Kuttner 2005;Piazzesi and Swanson 2008). The primary alternative to using futures contracts to isolate monetary policy surprises is to use lower frequency changes in the federal funds rate, such as simple monthly first differences, or using some form of structural-identification scheme in a vector autoregression (VAR) (e.g., Evans 1999, 2005;Lioui and Maio 2014). Unfortunately, first differences do not distinguish between changes to monetary policy and changes in slow-moving and backward-looking economic conditions that drive policy.…”

“…To understand the economic source of FFED's asset pricing power, it is first useful to reconcile the positive risk premium earned by FFED with the negative risk premium prior studies estimate on monthly or quarterly changes in the federal funds rate and other short-term interest rates (e.g., Thorbecke 1997;Brennan, Wang, and Xia 2004;Petkova 2006;Lioui and Maio 2014;Maio and Santa-Clara forthcoming). If the Fed sets the federal funds target rate according to a Taylor (1993)-type rule, then the federal funds rate is an increasing function of the output gap and inflation.…”