The Equity Premium Puzzle and the Federal Reserve’s Stock Valuation Model

Abstract

We test a model to estimate the equity risk premium based on a stock valuation model suggested by former Federal Reserve Chairman, Alan Greenspan. The model suggests that the stock market is fairly priced when the price of the market portfolio is equal to the ratio between market earnings and the yield on the 10-year Treasury bond. From this stock valuation model and extensions to it, we derive an equation for the expected market risk premium. Ex post we find that a model which accounts for corporate bond yields and the inherent differences between common stocks and Treasury bonds (most notably risk) provides a good estimate of the equity risk premium.

TOPICS: Analysis of individual factors/risk premia, factor-based models, statistical methods