Financial uncertainty, risk aversion and monetary policy

Bernanke and Kuttner (2005) state that the separation of the differences in anticipated and unanticipated shock to monetary policy is essential.

Literatures on variance risk premium include Carr and Wu (2009), Drechsler and Yaron (2011), Christiano et al. (2013), Popescu and Smets (2010).

For detail explanation, see Borio and Zhu (2012).

While examining the effect of monetary policy on stock market risk aversion, Bekaert et al. (2013) decompose squared VIX into uncertainty (expected stock market variance) and risk aversion. [The square of VIX is a notable measure of US market uncertainty which appears in a seminal work by Bloom (2009). VIX is a measure of “risk-neutral” or implied volatility that is the option-implied expected volatility on the S&P 500 index with a horizon of 22 trading days (30 calendar days)]. They find that lax monetary policy reduces expected stock market volatility and risk aversion with a weaker effect on expected stock market volatility. In the medium run, decline in industrial production growth occurs due to contractionary monetary policy shock, while growth in industrial production is lowered by positive uncertainty shocks.

At macro and micro levels, the risk-taking channel constitutes a concern. While examining the characteristics of the transmission mechanism, business cycle and capital regulation interaction, Borio and Zhu (2012) suggest that risk-taking channel of monetary policy (monetary policy linkage with risk pricing and perception by economic agents) receives little attention. They argue that the increment in the vitality of the risk-taking channel might be due to prudential regulation, changes in the financial sector, the associated models and prevailing macroeconomic paradigms do not capture it appropriately and thus, a reduction in their effectiveness as monetary policy guides.

Examples include Thorbecke (1997), Rigobon and Sack (2004) and Bernanke and Kuttner (2005), while Vázquez (2009) examines the reaction of the Fed funds rate to the term spread.

For detailed explanation refer to Barndorff-Nielsen and Shephard (2006), Barndorff-Nielsen and Shephard (2004), Huang and Tauchen (2005), Andersen et al. (2007).

Comprehensive detail exist in Kuttner (2001) and Gurkaynak et al. (2005).

From model-free option-implied and realised volatility, Bollerslev et al. (2011) propose the construction of investor risk aversion index (volatility risk index). They implement their construct on 1990–2004 data from Chicago Board of Options Exchange. Using Monte Carlo simulations and GMM estimation technique, they establish that realised volatilities approximate well to continuous-time integrated volatility than volatility based on sum of daily squared returns. In addition, evidence of temporal variation of risk premium volatility exists and future stock market returns is predictable from the extracted risk premium volatility. They show that negative coefficient of volatility risk premium \(({-\lambda })\) is approximately equal to constant relative risk aversion \((\gamma )\) and also applies relatively to time-varying risk aversion. Kanas (2013) examines the relationship between VIX and risk-return.

Variance risk premium is investors’ premium for the acceptance of unpredictable future variance or the expected premium for the sale of a stock market variance in a swap contract.

Given that 500 companies are involved, we obtain monthly implied volatility for each company.

The winsorized sample is employed and the \(VIX^{2}\) is divided by \( 10^{4}\) to make it comparable with realised variances.

Refer to Rubio-Ramírez et al. (2010).

See for example Andersen et al. (2003), Chuliá et al. (2010).

We identify these positive dummies from monthly changes in Fed target rate and then interact it with the cleansed monetary policy surprise measure.

These are applied in Bjørnland and Leitemo (2009), and Doan (2004) and are obtained from Monte Carlo integration with 5000 replications for just-identified systems, which is Bayesian simulated distribution.