The Fed S Policy Decisions and Implied Volatility

1

THE FED’S POLICY DECISIONS AND IMPLIED VOLATILITY

Sami Vähämaa[*], Janne Äijö[**]

Department of Accounting and Finance

University of Vaasa, Finland

March 18, 2010

Abstract

This paper examines how the Fed’s monetary policy decisions affect the implied volatility of the S&P 500 index. The results show that option-implied stock market uncertainty is significantly affected by monetary policy decisions. In particular, we find that stock market volatility generally decreases after the FOMC meetings. However, our results also indicate that stock market uncertainty may increase after positive target rate surprises. We further document that the policy decisions made in unscheduled FOMC meetings exert a stronger influence on volatility. Finally, our findings demonstrate that the impact of policy decisions on implied volatility is more pronounced during periods of expansive monetary policy.

JEL classification: E44, E52, E58, G10, G13

Keywords: Monetary policy decisions, stock market uncertainty, implied volatility

INTRODUCTION

Monetary policy decisions of central banks are often associated with large stock price movements. Bernanke and Kuttner (2005), for instance, document that an unexpected 25 basis points cut in the target rate of the Federal Reserve typically increases stock prices in the U.S. by around one percent. Similar findings on strong stock market reactions to monetary policy decisions are recently reported e.g. in Ehrmann and Fratzscher (2004, 2009), Wang, Yang and Wu (2006), Chen (2007), Basistha and Kurov (2008), Bohl, Siklos and Sondermann (2008), Ioannidis and Kontonikas (2008), Kholodilin, Montagnoli, Napolitano and Siliversotvs (2009), Wongswan (2009), and Kurov (2010). While the effects of monetary policy actions on stock prices have been examined extensively in the prior literature, considerably less attention has been given to the effects of monetary policy on stock market volatility. Thus, in this paper, we aim to contribute to the literature by examining the effects of the Federal Reserve’s monetary policy decisions on the implied volatility of the S&P 500 index.

Previously, the effects of monetary policy decisions on stock market volatility have been studied in Lobo (2002), Bomfim (2003), Nikkinen and Sahlström (2004), Chen and Clements (2007), Farka (2009), Andersson (2010), and Chuliá, Martens and van Dijk (2010). Lobo (2002) and Bomfim (2003) apply GARCH modelling to ascertain the impact of monetary policy on stock market volatility, and document a significant increase in volatility on the days of monetary policy announcements. Farka (2009), Andersson (2010) and Chuliá et al. (2010) use intraday data to examine volatility dynamics around monetary policy meetings. Consistent with Lobo (2002) and Bomfim (2003), these studies report large increases in stock market volatility in the immediate aftermath of monetary policy decisions. Farka (2009) and Chuliá et al. (2010) further show that the increase in volatility is substantially larger during recessions and expansive monetary policy cycles than during periods of restrictive policy.

Most related to the our paper, Nikkinen and Sahlström (2004) and Chen and Clements (2007) focus on the behaviour of implied volatility indices around the Federal Open Market Committee (FOMC) meetings, and document systematic decreases in implied volatility on the FOMC meeting days. In contrast to studies based on realized volatility, Nikkinen and Sahlström (2004) and Chen and Clements (2007) exclude unscheduled monetary policy decisions, and moreover, ignore the potential surprise components of the policy announcements.

In this paper, we extend the analysis of Nikkinen and Sahlström (2004) and Chen and Clements (2007) in three main respects. First, we use fed funds futures contracts to extract surprises in monetary policy decisions, and are thereby able to assess the impact of monetary policy shocks on stock market uncertainty. Second, given that the policy decisions made in scheduled and unscheduled FOMC meetings are likely to affect market uncertainty somewhat differently, we differentiate between scheduled and unscheduled policy actions in our empirical analysis. Third, recent empirical evidence suggests that the reaction of stock markets to monetary policy is asymmetric and may depend on the monetary policy cycle and macroeconomic conditions (see e.g., Chen, 2007; Basistha and Kurov, 2008; Farka, 2009; Chuliá et al., 2010; Kurov, 2010). Therefore, we attempt to extend the literature by examining the potential cyclical variation in the effects of policy decisions on option-implied stock market volatility.

Our empirical findings demonstrate that stock market uncertainty is significantly affected by monetary policy decisions. Consistent with Nikkinen and Sahlström (2004) and Chen and Clements (2007), we find that implied stock market volatility generally decreases after FOMC meetings. However, our results also indicate a positive relationship between monetary policy surprises and implied volatility, thereby suggesting that positive target rate surprises, i.e. larger than expected rate increases and smaller than expected rate cuts, may actually increase stock market uncertainty. Furthermore, our findings demonstrate that target rate decisions made in unscheduled FOMC meetings have a stronger effect on implied volatility. Finally, consistent with Farka (2009) among others, we document that the impact of monetary policy decisions on stock market volatility is more pronounced during periods of expansive monetary policy.

DATA

The data used in our empirical analysis consist of (i) the VIX implied volatility index, (ii) the monetary policy decisions of the Federal Reserve, and (iii) federal funds futures prices. The sample period spans from January 3, 1994 through December 31, 2007. This sample includes 120 FOMC meetings and a total number of 53 changes in the federal funds target rate. Following Bernanke and Kuttner (2005), Basistha and Kurov (2008), and Kurov (2010), we exclude the monetary policy decision made in the immediate aftermath of the terrorist attacks on September 17, 2001.

We measure stock market uncertainty with the VIX implied volatility index. VIX index is calculated from S&P 500 index options by the Chicago Board Options Exchange (CBOE). The volatility index is constructed from short-term out-of-the money call and put options and represents the expected volatility of the S&P 500 index over the next30 days (for details, see e.g. Chicago Board Options Exchange, 2009; Whaley, 2009). VIX index has been widely used in prior literature to measure uncertainty in stock markets (see e.g., Connolly, Stivers and Sun, 2005; Bialkowski, Gottschalk and Wisniewski, 2008).

We use federal funds futures contracts to extract surprises in monetary policy decisions of the Federal Reserve. Previous studies have shown that federal funds futures rates provide an efficient measure of expectations regarding the Fed’s monetary policy decisions (see e.g., Krueger and Kuttner, 1996; Söderström, 2001).In this paper, we apply the approach proposed in Kuttner (2001) and Bernanke and Kuttner (2005) to measure monetary policy surprises. Thus, the surprise component of the federal funds target rate decision is based on the daily changes in the implied target rate of the current-month fed funds futures contract:

(1)

where is the unexpected component of the announcement, is the first difference operator, is the current-month futures rate at the end of the FOMC day d and D is the number of days in the month. This approach to measure monetary policy surpriseshas been recently used e.g. in Bomfirm (2003),Wang et al. (2006), Basistha and Kurov(2008) and Chuliá et al.(2010).

(Insert Table 1 about here.)

Table 1 reports descriptive statistics of the sample. As can be seen from the table, the sample includes 112 scheduled FOMC meetings and 7 unscheduled meetings. The monetary policy decisions of the Federal Reserve have generally been well anticipated by investors, as the mean (median) monetary policy surprise is only -1.88 (-1.00) basis points. Not surprisingly, the unscheduled FOMC meetings are associated with much larger policy surprises, with a mean (median) surprise estimate of -22.75 (-29.25) basis points. Regarding the VIX index, Table 1 shows that implied volatility of the S&P 500 index has, on average, been about 19.4 %, and varied between 6.7 % and 45.7 % over the sample period.

RESULTS

Monetary Policy Decisions and Stock Market Uncertainty

To examine the impact of the Fed’s monetary policy decisions on stock market uncertainty,we regress the daily changes in implied volatility indexon alternative monetary policy variables:

(2)

where denotes implied volatility (the VIXindex) at time t, Δ is the first difference operator and FOMCtis defined as one of the following monetary policy variables: (i) a meeting dummy that takes the value of one on the FOMC meeting days,(ii)monetary policy surprise variable defined based on Equation (1), (iii)scheduled surprise variable that identifies policy surprises in scheduled FOMC meetings, (iv)unscheduled surprise variable that identifies policy surprises in unscheduled FOMC meetings. In addition, we also estimate a fifth regression specification in which the monetary policy surprise variable is divided into positive and negative surprises.

Throughout the regressions, we use White’s heteroskedasticity consistent covariance matrix estimator. The Ljung-Box statistic indicates significant serial correlation in the residuals of the regressions, and hence, AR(p) terms are added to the models. Moreover, since Engle’s LM test indicates significant serial correlation in the squared residuals of the regressions, we also fit a GARCH(1,1) structure.

(Insert Table 2 about here.)

Table 2 reports the regression results for theimpact of monetary policydecisions on implied volatility. In Model (1), daily changes in the VIX index are regressed on the FOMC meeting dummy. Thus, in essence, this model provides a re-examination of the findings documented in Nikkinen and Sahlström and Chen and Clements (2007). Consistent with the previous studies, our results indicate thatimplied volatility decreases on the FOMC meeting days, as the potential policy-induced uncertainty is resolved by the market participants. Nevertheless, it should be noted that the approach based on the FOMC dummy variable ignores the actual policy decisions made in the meetings. Therefore, we next extend the analysis by taking into account the surprise components of policy decisions.

In Model (2), we regress implied volatility changes on monetary policy surprises. As discussed above, the Fed’s policy surprises are extracted from the fed fund futures contracts. The estimates of this regression show that surprises in monetary policy are positively associated with stock market uncertainty. Thus, our results indicate that positive target rate surprises (i.e., larger than expected target rate increases and smaller than expected rate cuts) increase option-implied stock market uncertainty, while negative surprises (i.e., smaller than expected target rate increases and larger than expected rate cuts) typically lead to a decrease in implied volatility. Positive (negative) surprises are obviously bad (good) news for the stock market, and thereby our findings are broadly consistent with the prior literature showing that bad news increase implied volatility (see e.g, Nofsinger and Prucyk, 2003).

In order to ascertain whether the policy surprises in scheduled and unscheduled FOMC meetings have a different impact on stock market uncertainty, we next regress implied volatility changes separately on the scheduled and unscheduled policy surprises (Models 3 and 4, respectively). Again, the estimated coefficients for both surprise variables are positive, and thereby suggest that monetary policy surprises are positively associated with stock market uncertainty. Nevertheless, our results indicate that the policy decisions made in the unscheduled FOMC meetings exert a much stronger influence on implied volatility.

Finally, given that positive and negative policy surprises may potentially have an asymmetric effect on stock market uncertainty, we regress implied volatility changes on positive and absolute negative surprises (Model 5). As can be noted from Table 2, the estimated coefficient for the absolute negative surprise variable is negative, while the coefficient for the positive surprise variable is statistically insignificant. Thus, our findings suggest that stock market uncertainty decreases after good monetary policy news (i.e., smaller than expected target rate increases and larger than expected rate cuts).

Does Monetary Policy Cycle Matter?

So far, we have assumed that the impact of monetary policy decision on implied volatility is symmetric across monetary policy cycles, that is, the effects of policy decisions are the same during restrictive and expansive periods. However, the results recently reported inChen (2007), Basistha and Kurov (2008), Farka (2009), Chuliá et al. (2010), and Kurov (2010) suggest that the reaction of stock markets to monetary policy decisions may vary under different policy cycles and macroecomic conditions. Thus, to examine whether the Fed’s monetary policy decisions affect implied volatility differently during restrictive and expansive monetary policy periods, we estimate the following model:

(3)

where denotes implied volatility, Δ is the first difference operator and and denote monetary policy decision variables in restrictive and expansive monetary policy cycles, respectively, and thealternative policy variables used in the regression are as defined in Equation (2). Again, we remove the serial correlation in the residuals and squared residuals by adding AR(p) and GARCH (1,1) terms into the models.

(Insert Table 3 about here.)

Table 3 reports the regression results for the effects of monetary policy decisions on implied volatility under different monetary policy cycles. In Model (6), daily changes in the VIX index are regressed on the restrictive and expansive FOMC meeting dummies. Our estimates indicate that the previously documented decrease in implied volatility on the FOMC meeting days (see Table 2) can be attributed solely to the FOMC meetings in an expansive monetary policy cycle. This result extends the findings on the FOMC day effects reported in the prior literature (see Nikkinen and Sahlström, 2004; Chen and Clements, 2007).

Model (7) is applied to examine the impact of monetary policy surprises on implied volatility in different policy cycles. As can be noted from Table 3, the coefficient estimate for the policy surprise in expansive cycle is positive, thereby indicating that smaller (larger) than expected interest rate cuts increase (decrease) stock market uncertainty. The estimated coefficient for the restrictive surprise variable is insignificant. Therefore, consistent with Model (6), the results suggest that the effect of policy decisions on implied volatility is larger during periods of expansive monetary policy.These results are broadly consistent withe.g. Chen (2007), Basistha and Kurov (2008), Farka (2009), and Kurov (2010), and thus, provide further evidence to suggest that stock markets are more strongly influenced by monetary policy decisions under adverse economic conditions.

In Models (8) and (9), we examine how implied volatility is affected by scheduled and unscheduled monetary policy surprises inexpansive and restrictivepolicy cycles. In general, the results again show that unscheduled policy surprises have a larger impact on implied volatility than scheduled surprises. In fact, the estimated coefficient for scheduled surprise in restrictive policy cycle is statistically insignificant, and the coefficient for the scheduled surprise in expansive policy cycle is positive and significant at the 10 % level. In contrast, the coefficients for the unscheduled surprises both in restrictive and expansive monetary policy cycles are statistically highly significant. Thus, regardless of the monetary policy cycle, our results indicate that positive (negative) target rate surprises in unscheduled FOMC meetings increase (decrease) stock market uncertainty.

Finally, in Model (10), implied volatility changes are regressed on positive and absolute negative surprises in expansive and restrictive policy cycles. The estimates of Model (10) show that negative surprisesin expansive policy cycle (i.e., higher than expected target rate cuts) reduce stock market uncertainty. This finding further demonstrates that the effects of monetary policy decisions on implied volatility are more pronounced during periods of expansive monetary policy.

CONCLUSIONS

This paper focuses on the impact of monetary policy decisions on stock market uncertainty. In particular, we examine how the Fed’s policy decisions affect the implied volatility of the S&P 500 index. We use fed funds futures contracts to extract surprises in monetary policy decisions, and assess the effects of monetary policy shocks on implied volatility. Furthermore, we also examine whether the policy surprises in scheduled and unscheduled FOMC meetings affect stock market uncertainty differently. Finally, we attempt to extend the literature by examining the potential cyclical variation in the effects of policy decisions on option-implied stock market volatility.

The empirical findings reported in this paper demonstrate that stock market uncertainty is significantly affected by monetary policy decisions. Consistent with the prior literature, we find that implied stock market volatility generally tends to decrease after FOMC meetings. However, our results also indicate a positive relationship between monetary policy surprises and implied volatility, thereby suggesting that positive target rate surprisesmay increase stock market uncertainty. Furthermore, our findings suggest that target rate decisions made in unscheduled FOMC meetings have a stronger effect on implied volatility than scheduled policy decisions. Finally, we document that the impact of monetary policy decisions on implied volatility depends on the prevailing monetary policy stance, as the market reaction to policy surprises is more pronounced during periods of expansive policy.

Bibliography

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