Monetary Policy, External Finance Dependence, and the Cross-section of Stock Returns: A FAVAR Approach

We use an identified factor-augmented vector autoregression (FAVAR) to estimate the impact of monetary policy shocks on the cross-section of stock returns. Our FAVAR combines unobserved factors extracted from a large set of financial and macroeconomic indicators with the Federal Funds rate. We find that monetary policy shocks have heterogeneous effects on the cross-section of stock returns. These effects are well explained by the degree of external finance dependence, and by variables that arguably correlate with it. We also find that the cross- section of stock return responses to monetary policy shocks can be very well explained by the response of the Fama-French factors to those shocks.