The calming of short-term market fear and its long-term consequences: The central banks’ dilemma

We study the short-term effects and long-term consequences of Fed crisis interventions on market fears — the risk perception of large asset price drops. We extract daily fear term structures from option markets covering event horizons from two weeks up to 10 years ahead and use announcement surprises in a broad set of futures contracts and ETFs, covering equity, fixed income, and FX markets, to identify the unexpected component of Fed interventions. Focusing on the 2020 market turmoil, we find that the Fed impacts market fear via risk sentiment and information channels. The risk sentiment channel is the dominant channel for asset purchases and operates at the short to medium term. In contrast, the information channel strongly impacts long-term fears and is the dominant channel for interest rate policies.

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