Show Me the Money : The Monetary Policy Risk Premium

We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that previous studies link to how stocks react to monetary policy. Our index successfully captures stocks' responses to both conventional and unconventional monetary policy. Stocks whose prices react more positively to expansionary monetary policy (high-MPE stocks) earn lower average returns. This result is consistent with the notion that high-MPE stocks provide a hedge against bad economic shocks, to which the Federal Reserve responds with expansionary monetary policy. A long-short trading strategy designed to exploit this effect achieves an annualized Sharpe Ratio of 0.77