Nonlinearity in stock returns: Do risk aversion, investor sentiment and, monetary policy shocks matter?

Abstract

This paper examines the nonlinear effect of risk aversion, monetary shocks and sentiment changes, on index returns for a set of developed countries. We employ a smooth transition model, in which, these leading stock return drivers are separately considered as a threshold variable. Results show that index returns fall as investors become more risk averse following a positive shock to the volatility index for most of the markets. A restrictive monetary policy negatively affects index returns, in the low regime for some countries, and such an effect turns to be larger in the high regime for more liquid markets. When investors exhibit extreme pessimism or optimism, the market smoothly switches from bear to bull states according to the heterogeneous reactions of market participants and the degree of compensation for taking additional trading risks. Assessment of the predictive performance provides compelling evidence for the supremacy of the model with monetary shocks as a transition variable over competing models.