POLICY AND VOLATILITY OF ASSET RETURNS

During the last 10 years, a number of papers documented the time-varying conditional volatility of asset returns. Although these papers contribute significantly to our understanding of the nature of volatility, they do not typically provide an economic explanation of volatility. One possibly important variable that is correlated with volatility is policy. This paper examines the connection between volatility and policy in the context of two very closely watched actions of the Federal Reserve: open market operations in the domestic market, and sterilized intervention in the foreign exchange market. The results of the paper suggest that policy responds to volatility in the exchange rates and also to volatility in short-term interest rates. Additionally, there is some evidence indicating that policy reduces volatility in asset returns.