Wednesday, July 11, 2012

Equity Premium: Over 80% Gained in the 24 Hours Preceeding FOMC Announcement

The hell you say.
From the Federal Reserve Bank of New York's Liberty Street Economics blog:

The Puzzling Pre-FOMC Announcement “Drift” 
For many years, economists have struggled to explain the “equity premium puzzle”—the fact that the average return on stocks is larger than what would be expected to compensate for their riskiness. In this post, which draws on our recent New York Fed staff report, we deepen the puzzle further. We show that since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)—a phenomenon we call the pre-FOMC announcement “drift.”

    The equity premium is usually measured as the difference between the average return on the stock market and the yield on short-term government bonds. Previous research on the size of the premium finds that it is too large for plausible levels of risk aversion (see Mehra [2008] for a review).

The Drift: A First Take

The pre-FOMC announcement drift is best summarized in the chart below, which provides two main takeaways:
  1. Since 1994, there has been a large and statistically significant excess return on equities on days of scheduled FOMC announcements.

  2. This return is earned ahead of the announcement, so it is not related to the immediate realization of monetary policy actions.

Returns-on-sp-500

    The chart shows average cumulative returns on the S&P 500 stock market index over different three-day windows. The solid black line displays the average cumulative return starting at the market’s opening on the day before each scheduled FOMC announcement to the market’s close on the day after each announcement....MORE