Risk, Uncertainty and Monetary Policy

Abstract

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...

Does Monetary Policy Affect Stock Market Uncertainty? Empirical Evidence from the United States

“…In line with the literature (see e.g. Bekaert and Hoerova (2010)) the monetary policy stance is measured by the real interest rate in percent r t = i t − π t , where i t equals the monthly average 7 Due to the fact that the inverse of the conditional distribution C −1 t|t−1 does not exist in closed form, the empirical V IX quantile u t = C −1 t|t−1 (0.5| u t−1 ; α, β) can be obtained from the equation 0.5 = C t|t−1 ( u t | u t−1 ; α, β) using a numerical root-finding routine (here: Newton's procedure). Hence, numerical imprecisenesses of the root-finding routine can lead to obvious outliers and can be substituted by local means.…”

“…This monetary policy transmission can lead to financial instability and can affect stock market uncertainty. Regarding this literature Bekaert and Hoerova (2010) investigate the direct effect of monetary policy on stock market uncertainty, which seems to be insignificant. However, they derive a link between monetary policy and risk aversion, which potentially affects stock market uncertainty.…”

Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk-Taking?

“…investors to bear risk (see also Rigobon and Sack (2004) and Bekaert, Hoerova, and Lo Duca (2010)). Expansionary monetary policy and credit risk-taking followed by restrictive monetary policy possibly led to the financial crisis during the 1990s in Japan (Allen and Gale (2004)), while lower real interest rates preceded banking crises in 47 countries (von Hagen and Ho (2007)).…”

The Nelson–Siegel Model of the Term Structure of Option Implied Volatility and Volatility Components

“…Engle and Rangel (2008) and Park (2011) both argue that long-term volatility is associated with macroeconomic shocks. More recently, Bekaert, Hoerova, and Duca (2010) show that the VIX commoves with monetary policy shocks. Whereas the short-term volatility componentb 2t is highly correlated with the VIX, we conjecture that it is also related to monetary policy variables.…”