Stock Market Responses to Fed Funds Rate Changes

Proponents of the semi-strong form of the Efficient Market Hypothesis argue that stock prices fully reflect all publicly available information.Furthermore, economic models assume that investors rationally evaluate future market performance and that there is no systematic bias ininvestor expectations. This paper empirically evaluates these hypotheses in the context of stock market response following the FOMC’sannouncements on the target fed funds rate. In particular, the paper shows that investors systematically underestimate stock market response tothe fed funds rate changes, which creates profitable arbitrage opportunities.