The Interactions between Monetary Policy and Option-based Implied Volatility: Evidence from Europe

I investigate the interactions between monetary policy and option-based implied volatility of stock markets indices in Germany, the Eurozone and Switzerland. Implied volatility constitutes an important economic variable as it incorporates information on the expected volatility of a stock index and on investors’ risk aversion. The analysis is performed using a VAR methodology. I control for the business cycle and in the case of Switzerland, also for the exchange rate. The results mostly indicate that expansionary monetary policy, measured by nominal and real interest rates, significantly decreases implied volatility. In addition, I find that the ECB accommodates positive implied volatility shocks by lowering interest rates. Opposed to this, I do not find evidence that the Swiss National Bank reacted in a similar way to implied volatility prior to the Great Recession, nor do I find evidence that the German Bundesbank did so prior to the introduction of the euro. When measuring the monetary policy stance using the growth rate of monetary aggregates, I obtain more mixed results. However, the findings based on interest rates should be of greater importance, given that central banks nowadays mostly use this tool to implement their policy