Equity market valuation, systematic risk and monetary policy

This study examines the relationship between equity market valuation and risk indicators that portend economic downswings. The indicators are implied options volatility, Treasury-Eurodollar (TED) spread and exchange rate. While implied volatility captures market risk in that it reflects the fear factor embedded in the price of an option, TED spread reflects the default risk premium that is priced into a key short-term credit instrument. Equity markets often show a tendency to reflect the incidence of these risk factors. And because they provide valuable information about the health of the economy, many have argued that equity market valuation be taken into account in the formulation of monetary policy. Results of this study not only show a statistically significant inverse relationship between the stock market and these risk factors, but also evidence of a cointegration. In a variance decomposition of the series, we find that equity valuation is a major contributor to the forecast error variances of each of the risk indicators, a finding that lends tacit support to the argument that risk indicators associated with the equity market be considered in monetary policy decisions.