The Cross-Section of Stock Returns and Monetary Policy: The Roles of the Capital Market Imperfection and Interest Rate Channel

This study investigates whether monetary policy shocks identified from Bayesian estimation of New-Keynesian dynamic stochastic general equilibrium (DSGE) models are critical for understanding the risk premium in stock markets. As test assets, I use the cross-section of average returns on either the Fama-French 25 size and B/M sorted portfolios alone or with 30 industry portfolios. Empirical resultsreveal that the implied ICAPMs are at least comparable to or better than the Fama-French three-factor model for the periods of 1980 to 2004. In particular, the permanent monetary policy shocks to inflation target are crucial for capturing the value premium and part of industry risk premium once I account for the capital market imperfection endogenously in New-Keynesian models following the specifications proposed by Graeve (2006). The shocks to investment technology, as a main determinant of the external finance premium, are also important for understanding the value premium.