The Market Price of Risk and Macro-Financial Dynamics

IMF Working Papers, September 22, 2023

Source details

Constructed the Volatility Financial Conditions Index (VFCI) as the component of the market price of risk spanned by financial assets.
Showed how to estimate the VFCI from the conditional volatility of GDP using a no-arbitrage model with general preferences, valid even when markets are incomplete.
Empirical headline: the VFCI has greater predictive power than other Financial Conditions Indexes (FCIs) for equity, Treasury, and corporate bond risk premia.
Key dynamic relationships:
- A VFCI shock that tightens financial conditions causes a persistent decline in output and an immediate monetary policy easing.
- Contractionary monetary policy shocks cause financial conditions to tighten.

Theoretical framework:
- No-arbitrage asset-pricing model with general preferences to link the market price of risk to macroeconomic volatility.
- Identification of the VFCI as the portion of the market price of risk spanned by financial assets.
Estimation strategy:
- Estimate the VFCI from the conditional volatility of GDP, allowing for market incompleteness.
- Multiple identification strategies used in empirical analysis (details in full text).

Predictive performance:
- VFCI outperforms other FCIs in predicting equity risk premia.
- VFCI outperforms other FCIs in predicting Treasury risk premia.
- VFCI outperforms other FCIs in predicting corporate bond risk premia.
Dynamic responses (across multiple identification strategies):
- VFCI tightening → persistent decline in output.
- VFCI tightening → immediate monetary policy easing.
- Contractionary monetary policy shock → tightening of financial conditions.

Financial-condition shocks captured by the market price of risk (VFCI) have macroeconomic consequences that persist for output and interact with monetary policy.
Monetary policy responds to VFCI tightenings with immediate easing, indicating monetary authorities react to financial-market-driven tightening.
Tightening of monetary policy can feed back to financial conditions by tightening them, suggesting two-way interactions between monetary policy and financial-market risk pricing.