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Global Funding Liquidity, Equity Returns And Crash Risk: Implications For Monetary Policy

Date Added: Feb 2010
Format: PDF

Monetary policy loosening and the associated impact on credit availability may have played a role in the present financial crisis. If such liquidity risk exists and is undiversifiable, then loose monetary policy should be associated with a risk premium. This paper tests for the existence of such a premium in US and global equity markets, in an asset pricing framework which accounts for endogeneity from equity prices to credit availability. This paper asks whether equity market returns incorporate a risk premium for low interest rates, opposing the usual prediction that high interest rates constitute a risk factor. Low interest rates could constitute a risk factor if they lead to excess leverage, thus increasing crash risk.