Effect of Monetary Policy on Small- versus Large-Cap Stock Performance

Abstract

This thesis aims to examine differences in responses of small–cap and large-cap stocks on the Frankfurt Stock Exchange, as a result of monetary policy changes. With focus on interest rate changes. Previous research has established a strong connection between monetary policy and general performance of stocks, this paper finds firm size to be an important differentiating factor. Using a quantitative approach, this thesis uses multivariable OLS regressions on monthly returns from Frankfurt Stock Exchange. The findings show that small-cap stocks are more negatively affected by increases in ECB policy rates. Money supply and inflation also affect returns, with small-caps being comparatively less sensitive to increases in money supply. All stocks are negatively affected by inflation. In a second OLS regression, dividing restrictive and expansionary monetary policy periods, small-caps outperform large-caps in expansionary monetary policy (1.4% vs. 1.19% monthly return) but underperform significantly in restrictive periods (–0.58% vs. 0.69%). The results show that monetary policy does not just affect market-wide returns but also affects firms disproportionately by their size.