Risk and Risk-Free Rates
Prof. Mete Kilic
Assistant Professor of Finance and Business Economics
Marshall School of Business
University of Southern California
Risk-free interest rates and the VIX index comove negatively on average, as predicted by precautionary savings. But this comovement turns positive on FOMC days. This pattern is consistently observed across a diverse array of risk-free interest rates, including nominal, real, swap, short-term, and long-term rates. Our high-frequency analysis reveals that the impact of monetary policy shocks on conditional risk in financial markets drives this result. We provide an explanation for these findings in a model where levered investors akin to financial intermediaries hold and price a risky asset, such as equity. Upon an unexpected positive monetary policy shock, equilibrium interest rates and levered investors’ borrowing costs increase persistently. This raises investors’ leverage and the volatility of stochastic discount factor, leading to lower risk appetite and amplified financial market risks.
