Monetary Policy Rate Uncertainty Predicts Higher Equity Volatility

What are the research questions?

Financial theory asserts a clear link between the risk-free interest rate and the pricing of equity securities, regardless of the time horizon. Therefore, the market’s opinion about the uncertainty of rates should improve models forecasting equity volatility in the short and long run. This article asks one basic question:

Do measures reflecting investor opinion of monetary rate changes improve the short and long-term performance of models that forecast volatility of equity returns?

What are the Academic Insights?

YES.As expected, a positive, significant relationship is observed over weekly,monthly, and quarterly horizons. Dependent variables tested include: lagged and recent return variances, negative return shocks, lagged squared option-implied volatility, and interest rate implied volatility from options on short-term interest rate futures. Also included, although with a weaker effect, was a component of the EPU index-the Monetary Policy Uncertainty component and a news-based monetary policy uncertainty index developed in previous research.The forecasting analysis was conducted for the realized weekly, monthly and quarterly return variances for the S&P 500, FTSE 100 and EuroStoxx 50 indices. All proxies for monetary uncertainty significantly improved the forecasting performance for volatility and variance of the 3 equity indices across weekly, monthly and quarterly time horizons.

Why does it matter?

The results presented in this article provide support for the notion that the market’s opinion of changes in the path of interest rates and monetary policy improves the prediction of equity price volatility.Furthermore, the methodologies described and used to analyze the main hypothesis, are useful for anyone attempting to forecast short and long-term volatility in equity prices.Advancements in the estimation of the variance risk premium via the improvement in estimates of the conditional variance, for equity indexes, is presented.