Premium
Market Volatility, Monetary Policy and the Term Premium
Author(s) -
Kumar Abhishek,
Mallick Sushanta,
Mohanty Madhusudan,
Zampolli Fabrizio
Publication year - 2023
Publication title -
oxford bulletin of economics and statistics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.131
H-Index - 73
eISSN - 1468-0084
pISSN - 0305-9049
DOI - 10.1111/obes.12518
Subject(s) - economics , volatility (finance) , monetary economics , monetary policy , shock (circulatory) , bond , yield curve , volatility risk premium , government bond , interest rate , implied volatility , econometrics , finance , medicine
Abstract In this article, we use time‐varying VAR models to study the effects of option‐implied measures of equity and bond market volatilities on the government bond term premium and key macroeconomic variables. We show that the high correlation between the two volatilities requires the shocks to these variables to be jointly identified. We find that a positive shock to the VIX reduces the term premium. We interpret this effect as the result of investors shifting their portfolios away from riskier assets. Also, a positive shock to the VIX has contractionary and disinflationary effects. By contrast, a positive shock to the Merrill Lynch Option Volatility Expectations (MOVE), which reflects heightened uncertainty about future changes in interest rates, raises the term premium. Similar to a VIX shock, an increase in bond market volatility also has a contractionary effect, although the negative effects on output and inflation are smaller. Both VIX and MOVE shocks resemble negative demand shocks, albeit of different intensity, to which the central bank responds by easing monetary policy. Depending on the type of volatility impacting the economy, a contraction in output can be associated either with a flattening or steepening of the yield curve.