Monetary Policy and Pricing of Cash-Flow and Discount-Rate Risk

Introduction For the past several decades the Sharpe-Lintner capital asset pricing model (CAPM) has been one of the cornerstones of modern financial theory. Empirical research, however, has uncovered anomalies that cast doubts about the single-factor CAPM. Two notable failures of the CAPM have been the model's inability to explain higher average returns on small stocks and value stocks. (l) Several authors also report that the market beta is not priced in empirical tests of the CAPM (see Fama and French, 1992 and 1996). Thus, empirical findings seem to indicate that the single-factor CAPM is misspecified. Campbell and Vuolteenaho (2004) split the market beta of the CAPM into two components: a cash-flow beta and a discount-rate beta. The sum of the two betas is equal to the market beta. They examine two different time periods--January 1929 to June 1963 (early sample), and July 1963 to December 2001 (modern sample). In the early sample, value stocks and small stocks have higher cash-flow and discount-rate betas than growth stocks and large stocks. Thus, the value premium and the size premium in the early sample are compensation for higher levels of risk. In the modern sample, value stocks have higher cash-flow betas than growth stocks, whereas growth stocks have higher discount rate betas. Campbell and Vuolteenaho (2004) report that the prices of cash-flow risk are significantly higher than the prices of discount-rate risk in both samples. Therefore, higher return on value stocks in the modern sample can be attributed to their higher cash-flow betas. Higher return on small stocks in the modern sample can be attributed to their greater exposure to discount-rate risk. Cash-flow betas for small stocks and large stocks in the modern sample are about equal. Thus size premium in the modern sample is explained by higher discount-rate risk for small stocks. Campbell and Vuolteenaho's model demonstrates that value and size premiums in equity returns are compensation for higher levels of risk. The CAPM thus is resurrected as a two-factor model. The single-factor model's inability to explain anomalies apparently is due to aggregation of the two betas into a single market beta. In this paper I examine pricing of cash-flow and discount-rate betas in different Fed monetary policy environments. There is ample evidence in the literature that monetary policy influences contemporaneous and ex ante stock returns. In two early studies Rozeff (1974 and 1975) reports that monetary developments influence a large fraction of stock return variation. Rozeff concludes that changes in Fed monetary policy strongly influence contemporaneous stock returns. [See Ewing (2001) and Bomfim (2003) for more recent evidence on the effects of monetary policy on stock return volatility. ] In another widely cited early paper Fama (1981) examines the relation between inflation and stock returns. He finds evidence of negative correlation and argues that stock returns and inflation are driven in opposite directions by anticipated real activity. Geske and Roll (1983), James, Koreisha, and Partch (1985), and Kaul (1987) argue that countercyclical Fed monetary policy explains this Fama hypothesis. The Fed pursues restrictive policy to curb inflation, which leads to lower stock returns. Zweig (1986) argues that the monetary climate is the dominant factor in determining the stock market's major direction. Smirlock and Yawitz (1985) contend that changes in monetary policy affect stock returns by influencing interest rate forecasts, the cost of capital, and investors' expectations of corporate profitability. Jensen, Mercer, and Johnson (1996) provide evidence that stock and bond returns are significantly higher in expansive monetary policy periods than in restrictive periods. [Also see Conover, Jensen, Johnson, and Mercer (2005) for more recent evidence. ] Stock returns are negative during restrictive monetary policy periods. They conclude that monetary stringency affects investors' required returns. …