Monetary policy and equity returns: The role of investor risk aversion

Abstract This article examines the role of investor risk aversion in the transmission of monetary policy to stock returns based on U.S. data. Our results show that following an expansionary monetary policy shock, investor risk aversion falls, leading to a decrease in the equity risk premium and an increase in equity returns. Moreover, the returns of high‐beta stocks increase much more than those of low‐beta stocks. Finally, we investigate the mechanism through mutual fund flows. We find that high‐beta funds attract greater inflows in response to lower interest rates, and there is a positive relationship between fund returns and flows. Our findings have policy implications for financial stability.