Quantitative easing, financial risk, and portfolio diversification

We assess the extent to which the aforementioned changed monetary conditions have affected the relationship between financial markets and some leading macro-finance indicators. In the first part, we thus examine the financialmarkets dynamics before and after February 2006. We find evidence supporting the view that the macro-finance foundation of market movements has changed substantially in the Bernanke period. If real interest rates could explain markets’ performance in the second part of the Greenspan tenure, the stochastic discount factor (SDF) seems to be the only factor capable of explaining financial markets movements after 2006. In the second part, we relate our findings to the extraordinary growth of money supply determined by the Federal Reserve’s choice of expanding its balance sheet by purchasing long-term Treasury securities. In addition, rather than focusing exclusively on money supply, we explore the role of the risk premium that seems to lie beneath the different outcome characterizing the Bernanke sample. Gagnon et al. (2011), in fact, find that the flattening of the yield curve is mostly due to declining term premia. Our empirical findings are in line with the achievements of modern macro-finance theory, according to which asset pricing is explained by time-varying risk aversion and the cyclical movements of term premia (Campbell and Cochrane, 1999; Brandt and Wang, 2003; Wachter, 2006; Li, 2007; Mele, 2007). In particular, we argue that risk premia are related to changes in both unemployment and risk aversion, finding evidence that the weak discounting process implied by high levels of risk aversion can explain the cyclical behavior of assets prices.