Monetary Policy, Stock Market Tail Risks, and the FOMC Announcement Premium

Monetary policy lowers stock market tail risks, both ex ante and ex post. By comparing the implied skewness of options that cover a scheduled FOMC announcement with options of the same duration but expire shortly before the announcement, we find that market participants anticipate monetary policy to increase the skewness of equity returns—with the increase being driven by the
reduction in left tail risks. Such expectations are unevenly distributed across firms and are realized ex post—stocks with a higher expected increase in skewness ex ante experience a larger increase in realized skewness. Firms are also found to experience a larger reduction in downside risks on FOMC days with accommodative (rather than contractionary) announcement surprises.

Referring to the component of monetary policy that reduces tail risks as the “Announcement-day Fed Put” (or AFP) and firms’ exposure to the AFP as their “Fed Put exposure” (or FPE), we find that FPE is priced. High FPE firms earn a higher announcement-day return premium than low FPE firms. Although monetary policy reduces tail risks, the extent to which it does so is uncertain ex ante and high FPE firms are more exposed to this uncertainty. Consistent with the funding
liquidity of financial intermediaries being a channel through which monetary policy can reduce tail risks, we find that high FPE firms are more exposed than low FPE firms to the capital shocks faced by New York Fed’s primary dealer counterparties in its implementation of monetary policy. The higher exposure of the high FPE firms are especially pronounced with respect to positive capital
shocks, i.e., enhanced funding liquidity of financial intermediaries. This symmetric pattern is consistent with AFP capturing a “put-option-like” component of monetary policy and high FPE firms being more exposed than low FPE firms to this component.