The differences in monetary policy risk premiums between central banks

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Journal Title

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Volume Title

School of Business | Master's thesis

Authors

Date

2023

Department

Rahoituksen laitos

Major/Subject

Mcode

Degree programme

Finance

Language

en

Pages

92 + 27

Series

Abstract

Prior literature has documented that stock markets experience large average excess returns in anticipation of the Federal Open Market Committee (FOMC) monetary policy announcements. These FOMC announcement returns are statistically significant in multiple countries and account for a noticeable fraction of the yearly global stock market returns. While countries throughout the globe react to the scheduled FOMC monetary policy announcements, other central banks do not seem to have such an effect internationally or in their home markets. In addition, previous empirical studies have provided evidence that the capital asset pricing model (CAPM) is able to price the cross-section of asset returns on FOMC monetary policy announcement days, and again such a relation cannot be found for other central banks. This result suggests that the CAPM could, after all, be an important measure of systematic risk for a subset of trading days. In this paper, I study how prescheduled monetary policy announcements by the Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE), and Bank of Japan (BoJ) affect the risk and return on the global equity markets. Following earlier empirical literature, I show that global equity markets respond strongly to the FOMC monetary policy announcements, but a similar relation cannot be robustly detected for the ECB, BoE, and BoJ. I continue by studying the relation between the stock market beta and average excess returns on monetary policy announcement days, and explain why the CAPM, which is known to be misspecified, seems to be able to price the cross-section of asset returns on FOMC announcement days but fails on other trading days. I argue that the FOMC announcement day returns play a vital role in global yearly stock market returns, which indicates that the Fed holds a unique position in the global financial markets. I discuss how the Fed’s position does not seem to simply come from the size of the US economy or other countries’ exposure to multinational companies that generate a large share of their returns from the US. Even though central banks within the scope of the study have pursued active monetary policy during the research period, I show that the Fed typically acts as the leader in setting the global monetary policy. If the Fed indeed acts as the leader among central banks, then this could explain the global reaction to the FOMC monetary policy announcements as well as the lack of reaction to other central banks’ announcements. In addition to this hypothesis, I present and discuss multiple additional hypotheses and factors that could cause the Fed to be more important to global investors compared to the other non-US central banks.

Description

Thesis advisor

Nyberg, Peter

Keywords

monetary policy announcements, the Federal Reserve, asset pricing, capital asset pricing model

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Citation

Permanent link to this item

https://urn.fi/URN:NBN:fi:aalto-202311196882

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[gradu] Kauppakorkeakoulu / BIZ