Identification of Structural Monetary Policy Shocks and Evaluation of the Dynamic Response of Stock Returns: Emphasizing Investor Participation and Investor Sentiment

Davood  Bazrafshan; Farid Askari

Authors

Davood Bazrafshan PhD Student, Department of Economic Sciences, Ab.C., Islamic Azad University, Abhar, Iran Author https://orcid.org/0009-0001-2787-1792
Farid Askari Department of Economic Sciences, Ab.C., Islamic Azad University, Abhar, Iran https://orcid.org/0000-0003-1544-2007

Keywords:

Structural Monetary Policy Shock, Stock Returns, Investor Sentiment, Markov Switching, Tehran Stock Exchange

Abstract

This study aimed to identify structural monetary policy shocks in Iran and evaluate the dynamic response of Tehran Stock Exchange returns to these shocks while considering investor sentiment, risk aversion, institutional conditions, exchange-rate dynamics, and market regimes. This quantitative time-series study used monthly data from December 2008 to December 2024. The baseline dataset comprised 193 observations, with 184 effective observations in the final VAR/SVAR estimation after applying transformations and lags. The endogenous vector included changes in annual inflation, monetary-base growth, investor sentiment, changes in a market-based risk-aversion proxy, and stock-market returns, while governance, the global financial crisis, and monthly seasonal dummies were treated as exogenous controls. Stationarity was assessed using ADF, Phillips–Perron, and KPSS tests. A VAR(3) was selected based on diagnostic adequacy, and structural monetary shocks were identified through recursive Cholesky restrictions. Dynamic effects were evaluated using Wild Bootstrap impulse responses and forecast error variance decomposition. Robustness was examined by adding exchange-rate changes, and a two-state Markov Switching model was estimated to investigate regime-dependent effects. The stock-return response to a positive structural monetary shock was initially negative, reaching its largest baseline decline around the third month, but no response from impact through 12 months was statistically significant at the 5% level. Monetary shocks explained only 1.25% of return forecast-error variance after 12 months, whereas return-specific shocks explained 90.57%. The exchange-rate robustness model yielded the same inference. Changes in risk aversion significantly predicted returns, whereas investor sentiment did not show a significant overall effect. Markov Switching identified a calm/low-return regime and a volatile/high-return regime with expected durations of 15.68 and 9.77 months, respectively, but regime differences in the effects of risk aversion, sentiment, and monetary shocks were not significant at 5%. Structural monetary policy shocks had a limited direct effect on Tehran Stock Exchange returns, while market-specific shocks and changes in risk pricing were more influential, and nonlinear market behavior was expressed mainly through differences in return levels, volatility, and regime persistence rather than through significant regime-dependent monetary effects.

References

[1] P. Maio, "Another Look at the Stock Return Response to Monetary Policy Actions," Review of Finance, vol. 18, no. 1, pp. 321-371, 2014, doi: 10.1093/rof/rfs050.

[2] N. Yoshino, F. Taghizadeh-Hesary, A. Hassanzadeh, and A. D. Prasetyo, "Response of Stock Markets to Monetary Policy: The Tehran Stock Market Perspective," Journal of Comparative Asian Development, vol. 13, no. 3, pp. 517-545, 2014, doi: 10.1080/15339114.2014.985458.

[3] M. Salehi, M. Behname, and M. S. Adibian, "Structural Shocks in Monetary Policy, Exchange Rates, and Stock Prices Using SVAR in Iran," International Journal of Islamic and Middle Eastern Finance and Management, vol. 14, no. 5, pp. 908-927, 2021, doi: 10.1108/IMEFM-04-2018-0150.

[4] G. Sekandary and M. Bask, "Monetary Policy Uncertainty, Monetary Policy Surprises and Stock Returns," Journal of Economics and Business, vol. 124, p. 106106, 2023, doi: 10.1016/j.jeconbus.2022.106106.

[5] M. Naderi, A. Hadizadeh, and A. Mirzapour Babajan, "Investigating the Effects of Monetary Policy Shocks on Stock Price Bubbles: The Application of Structural Vector Autoregression with Time-Varying Parameters (SVAR-TVP)," Quarterly Journal of Economic Research (Sustainable Growth and Development), vol. 23, no. 2, pp. 193-218, 2023.

[6] Z. Zarei, M. Hemmati, and P. Davoudi, "Evaluating the Effects of the Monetary Policy on the Total Stock Market Index in the Iranian Economy: Using the TVP-VAR and GARCH Approaches," Iranian Economic Review, vol. 28, no. 3, pp. 899-920, 2024.

[7] K. Jahangiri and S. A. Hoseini Ebrahimabad, "The Study of Monetary Policy, Exchange Rate and Gold Effects on the Stock Market in Iran Using MS-VAR-EGARCH Model," Financial Research Journal, vol. 19, no. 3, pp. 389-414, 2017.

[8] R. Zare, "Monetary Policy and Stock Market Cycles in Iran," Quarterly Journal of Quantitative Economics, vol. 19, no. 1, 2022.

[9] A. Hashemi Sanjani, "Review to the Asymmetric Effect of Monetary Policy on Boom and Bust Cycles in the Iranian Stock Market," Journal of Money and Economy, vol. 19, no. 2, pp. 229-248, 2024, doi: 10.61882/jme.19.2.229.

[10] I. Chatziantoniou, G. Filis, and C. Floros, "Asset Prices Regime-Switching and the Role of Inflation Targeting Monetary Policy," Global Finance Journal, vol. 32, no. 1, p. 15, 2017, doi: 10.1016/j.gfj.2015.12.002.

[11] W. Wang, C. Su, and D. Duxbury, "Investor Sentiment and Stock Returns: Global Evidence," Journal of Empirical Finance, vol. 63, no. 365, p. 391, 2021, doi: 10.1016/j.jempfin.2021.07.010.

[12] Y. Kim and K. Y. Lee, "Impact of Investor Sentiment on Stock Returns," Asia-Pacific Journal of Financial Studies, vol. 51, no. 1, pp. 132-162, 2022, doi: 10.1111/ajfs.12362.

[13] J. Lao, H. Nie, and Y. Jiang, "Revisiting the Investor Sentiment-Stock Returns Relationship: A Multi-Scale Perspective Using Wavelets," Physica A: Statistical Mechanics and its Applications, vol. 499, no. 420, p. 427, 2018, doi: 10.1016/j.physa.2018.02.043.

[14] A. Soroushyar and S. Ali Ahmadi, "Examining the Role of Momentum and Investor Sentiment in Herding Behavior in the Tehran Stock Exchange," Investment Knowledge, vol. 5, no. 18, pp. 147-159, 2016.

[15] G. Gol-Arzi and S. Piri, "Examining the Impact of Investors' Emotional Decisions on the Occurrence of Crisis in the Tehran Stock Exchange," Financial Management Strategy, vol. 10, no. 2, pp. 99-116, 2022.

[16] O. Cepni and R. Gupta, "Time-Varying Impact of Monetary Policy Shocks on US Stock Returns: The Role of Investor Sentiment," The North American Journal of Economics and Finance, vol. 58, p. 101550, 2021, doi: 10.1016/j.najef.2021.101550.

[17] O. Cepni, R. Gupta, and Q. Ji, "Sentiment Regimes and Reaction of Stock Markets to Conventional and Unconventional Monetary Policies: Evidence from OECD Countries," Journal of Behavioral Finance, vol. 24, no. 3, pp. 365-381, 2023, doi: 10.1080/15427560.2021.1983576.

[18] X. Zeng, Y. Sun, Y. Xu, and H. Hu, "Monetary Policy Shocks, Investor Sentiment, and Stock Returns: Firm-Level Evidence from China," Emerging Markets Finance and Trade, vol. 61, no. 9, pp. 2859-2876, 2025, doi: 10.1080/1540496X.2025.2467819.

[19] G. Bekaert, E. C. Engstrom, and N. R. Xu, "The Time Variation in Risk Appetite and Uncertainty," Management Science, vol. 68, no. 6, pp. 3975-4004, 2022, doi: 10.1287/mnsc.2021.4068.

[20] S. J. Yoon, "Time-Varying Risk Aversion and Return Predictability," International Review of Economics & Finance, vol. 48, no. 1, p. 18, 2017, doi: 10.1016/j.iref.2017.02.006.

[21] Q. Zhang, T. Choudhry, J. M. Kuo, and X. Liu, "Does Liquidity Drive Stock Market Returns? The Role of Investor Risk Aversion," Review of Quantitative Finance and Accounting, vol. 57, no. 929, p. 958, 2021, doi: 10.1007/s11156-021-00966-5.

[22] Z. He, L. He, and F. Wen, "Risk Compensation and Market Returns: The Role of Investor Sentiment in the Stock Market," Emerging Markets Finance and Trade, vol. 55, no. 3, pp. 704-718, 2019, doi: 10.1080/1540496X.2018.1460724.

[23] D. Duxbury and W. Wang, "Investor Sentiment and the Risk-Return Relation: A Two-in-One Approach," European Financial Management, vol. 30, pp. 496-543, 2024, doi: 10.1111/eufm.12427.

[24] M. Dahmene, A. Boughrara, and S. Slim, "Nonlinearity in Stock Returns: Do Risk Aversion, Investor Sentiment and Monetary Policy Shocks Matter?," International Review of Economics & Finance, vol. 71, no. 676, p. 699, 2021, doi: 10.1016/j.iref.2020.10.002.

[25] M. Abbaszadeh, H. Rostami Jaz, M. Desineh, and M. H. Ranjbar, "Examining the Nonlinear Relationship between Risk Aversion and Stock Returns in the Iranian Capital Market," Audit Knowledge, vol. 24, no. 95, pp. 502-526, 2024.

[26] X. Liu, D. Margaritis, and P. Wang, "Stock Market Volatility and Equity Returns: Evidence from a Two-State Markov-Switching Model with Regressors," Journal of Empirical Finance, vol. 19, no. 4, pp. 483-496, 2012, doi: 10.1016/j.jempfin.2012.04.011.

[27] J. C. Cuestas and B. Tang, "A Markov Switching SVAR Analysis on the Relationship between Exchange Rate Changes and Stock Returns in China," International Journal of Emerging Markets, vol. 16, no. 3, pp. 625-642, 2021, doi: 10.1108/IJOEM-06-2019-0463.

[28] S. W. Low, L. T. Tee, and S. R. Kew, "Does the Quality of Governance Matter for Equity Market Risk? Evidence from Emerging and Developed Equity Markets," Journal of Business Economics and Management, vol. 16, no. 3, pp. 660-674, 2015, doi: 10.3846/16111699.2012.720595.

[29] P. K. Narayan, S. S. Sharma, and K. S. Thuraisamy, "Can Governance Quality Predict Stock Market Returns? New Global Evidence," Pacific-Basin Finance Journal, vol. 35, no. 367, p. 380, 2015, doi: 10.1016/j.pacfin.2015.02.007.

[30] D. Y. Aharon, A. S. Baig, and R. J. Delisle, "The Effects of Country Governance Quality on the Stability of Equity Markets," International Review of Finance, vol. 25, no. 3, p. e70033, 2025, doi: 10.1111/irfi.70033.

[31] H. Mir, A. Rahimipour, and S. A. Jalaei, "The Impact of Good Governance on Competitiveness in the Tehran Stock Exchange," Economic Progress Policy, vol. 7, no. 2, pp. 177-199, 2019.

[32] S. Neaime, "The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets," Emerging Markets Review, vol. 13, no. 3, pp. 268-282, 2012, doi: 10.1016/j.ememar.2012.01.006.