I am an Assistant Professor of Finance at Colorado State University. My research areas are asset pricing, financial econometrics, and monetary economics. I received my PhD in Economics from the University of California San Diego.
This paper asks how monetary policy shocks impact variance risk premia, and thus investor risk aversion, across bond and equity markets. I document the following results: First, contractionary monetary policy shocks increase variance risk premia in bond and equity markets. This implies an overall increase in investor risk aversion. Second, the increase in variance risk premia is driven primarily by an increase in option implied volatility, while realized volatility is relatively less affected. Thus, there is a substantial increase in the price of risk, but little increase in actual risk. Third, bond markets experience a positive return following a contractionary shock, while equity markets experience a negative return. This occurs because higher levels of risk aversion increase the attractiveness of safe assets, relative to riskier assets.
I analyze how the tone of central bank press conferences impacts risk premia in the currency market. I measure tone as the difference between the number of hawkish and dovish phrases made during a press conference. I consider two measures of risk premia. The first measure is implied risk aversion. This is based on the relationship between the option implied, or risk neutral distribution of returns, and the physical, or actual distribution of returns. I find that implied risk aversion increases when central banks are hawkish, and decreases when central banks are dovish. The second measure is the variance risk premium. This is the difference between option implied and realized variance, and reflects the cost of insuring against an unexpected increase in variance. I find that variance risk premia increase when central banks are hawkish, and decrease when central banks are dovish. The magnitudes are economically and statistically significant. A one standard deviation increase in the hawkishness of a press conference increases the one month variance risk premium by 4.7% per year, relative to the average of 28.9% per year.
Basic financial theory indicates that the ratio of the conditional density of the future value of a market index and the corresponding risk neutral density should be monotone, but a sizeable empirical literature finds otherwise. We therefore consider an option augmented density forecast of the market return obtained by transforming a baseline density forecast estimated from past excess returns so as to monotonize its ratio with a risk neutral density estimated from current option prices. To evaluate our procedure, we compare baseline and option augmented monthly density forecasts for the S&P 500 index over the period 1997–2013. We find that monotonizing the pricing kernel leads to a modest improvement in the calibration of density forecasts. Supplementary results supportive of this finding are given for market indices in France, Germany, Hong Kong, Japan and the UK.