The Monetary Impact on Return Variability and Market Risk Premia

Abstract

While the variation of the money stock has been regarded as one of the most important macroeconomic determinants in the pricing of various asset categories, capital market theory posits that asset prices will be determined by the values of specific parametric variables in an equilibrium asset pricing framework. If the two distinctive theses are correct, it seems reasonable to hypothesize that there exist some systematic relationships between money and the parameters of the capital asset pricing model. It is the main purpose of this paper to investigate the impact of monetary changes on the parametric variables in the Sharpe-Lintner-Black capital asset pricing model (CAPM). More specifically, particular emphasis is placed upon intertemporal variations of the market risk premium (i.e., the slope coefficient in the return-beta space of the security market line) and the market return variability (i.e., the nor? mal izing factor for systematic risk) as a function of the changes in the money supply. In order to generate theoretically meaningful hypotheses regarding the relationship between the exogenous macroeconomic variable and the specific para? meters embodied in the CAPM, it is necessary to specify the preference structure of investors by assuming particular classes of utility functions. Mossin [25], Lintner [20], Litzenberger and Budd [21], and Budd and Litzenberger [6] showed that the market price of risk (i.e., market risk premium divided by the norma1izing variance of return on the market portfolio) can be expressed in terms of