The Market Price of Risk and Macro-Financial Dynamics

Tobias Adrian, Fernando Duarte and Tara Iyer

No 2023/199, IMF Working Papers from International Monetary Fund

Abstract: We propose the conditional volatility of GDP spanned by financial factors as a “Volatility Financial Conditions Index” (VFCI) and show it is closely tied to the market price of risk. The VFCI exhibits superior explanatory power for stock and bond risk premia compared to other FCIs. We use a variety of identification strategies and instruments to demonstrate robust causal relationships between the VFCI and macroeconomic aggregates: a tightening of financial conditions as measured by the VFCI leads to a persistent contraction of output and triggers an immediate easing of monetary policy. Conversely, contractionary monetary policy shocks cause tighter financial conditions.

Keywords: Macro-Finance; Financial Conditions Index; Monetary Policy; Asset Pricing; Market Price of Risk; Consumption Volatility; Causal Identification; bond risk premia; contractionary monetary policy shock; tightening of financial conditions; VFCI shock; Structural vector autoregression; Consumption; Asset prices; Estimation techniques; Global (search for similar items in EconPapers)
Pages: 87
Date: 2023-09-22
New Economics Papers: this item is included in nep-ban, nep-cba and nep-fdg
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Working Paper: The Market Price of Risk and Macro-Financial Dynamics (2023)
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