The Cross Section of the Monetary Policy Announcement Premium

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Author Information : Hengjie Ai, University of Minnesota
Leyla Jianyu Han, University of Hong Kong
Xuhui (Nick) Pan, University of Oklahoma
Lai Xu, Syracuse University

Year of Publication : Journal of Financial Economics, forthcoming 2021

Summary of Findings : Using the expected option-implied variance reduction to measure the sensitivity of stock returns to monetary policy announcement surprises, this paper shows that monetary policy announcements require significant risk compensation in the cross section of equity returns.

Research Questions : How to reconcile the following three empirical facts
1: Federal Open Market Committee (FOMC) announcement days are associated with realizations of significantly higher average equity market returns compared to days without major macroeconomic announcements.
2: CAPM holds on macroeconomic announcement days. None of the known risk factors are powerful enough to overturn the CAPM on announcement days.
3: Firms with differing levels of sensitivity to monetary policy announcements also have differing expected returns on announcement days.
We develop a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve's interest rate target, which affects the expected growth rate of the economy. Our model accounts for the dynamics of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days.

What we know : From an investor's point of view, a long-short portfolio formed on our monetary policy sensitivity measure produces an average announcement-day return of 31.40 bps. In addition, the returns of EVR-sorted portfolios remain significant after controlling for market beta and other standard risk factors.
Why? We further demonstrate that the spread on the EVR-sorted portfolios reflects risk compensation for monetary policy announcements. We use measures of monetary policy announcement surprises constructed by Nakamura and Steinsson (2018) to show that i) the average monetary policy announcement surprises are indifferent from zero, and therefore rational expectations hold well in our sample period; and ii) the returns of the EVR-sorted portfolios are monotonic in their sensitivity to monetary policy surprises.

Novel Findings : FOMC announcements resolve uncertainty about the macroeconomy and monetary policy and are associated with reductions in the option-implied variance. Firms that are more sensitive to monetary policy announcements should experience a greater implied variance reduction after announcements. Expectations for the implied variance reduction can therefore measure sensitivity to monetary policy announcements. Indeed, we find that portfolios sorted on the expected implied variance reduction (EVR) yield a significant spread in average returns on FOMC announcement days but not on non-FOMC trading days.

Abstract : Using the expected option-implied variance reduction to measure the sensitivity of stock returns to monetary policy announcement surprises, this paper shows that monetary policy announcements require significant risk compensation in the cross section of equity returns. We present evidence that our sensitivity measure captures the exposure of stock returns with respect to growth rate expectations. We develop a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve's interest rate target, which affects the expected growth rate of the economy. Our model accounts for the dynamics of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days.

Lai Xu
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