Monetary policy and asset returns

The essays of this dissertation focus on examining the cross-sectional variation of the relation between asset returns and monetary policy innovations. The first essay provides a discussion of different potential measures of monetary policy and concludes that the federal funds rate target is likely to be the variable that best captures monetary policy changes in the context of examining asset returns. This essay also provides a superior measure of the unexpected component of monetary policy surprises by incorporating market-based and macroeconomic variables that lead to predictability in changes of the funds rate target.; The second essay incorporates monetary policy into a multifactor model of asset prices by using proxies for changes in Fed policy to supplement the 3-factor model of Fama and French (1993). In this context, several different hypotheses regarding the cross-sectional differences in loadings on the monetary policy factor are examined. The credit channel hypothesis of monetary policy transmission predicts that firms with higher dependence on bank credit are more sensitive to policy changes. Similarly, Cooley and Quadrini (1999) present a general equilibrium model of firms' financial decisions which predicts the returns of smaller firms will react more to monetary policy changes. Finally, firms with more growth options are hypothesized to be more sensitive to policy changes. Support is found for all three hypotheses and additional evidence regarding the effect of monetary policy on future cash flows and discount rates is provided.; The final essay analyzes high frequency asset returns surrounding funds rate target innovations. The results indicate that market interest rates and stock prices react to policy innovations: Treasury security and stock index prices are negatively related to innovations in the federal funds rate target. In addition, the value of the dollar relative to foreign currency is positively related to policy innovations. An analysis of intraday stock index and interest rate futures data provides evidence that the explainable portion of asset price responses occurs, on average, within 40 minutes of a policy innovation. Return volatility of stock index and Treasury futures is higher than normal for approximately 40 minutes after changes in the federal funds rate target.