Working Paper: CEPR ID: DP3041
Authors: Marcus Miller; Paul Weller; Lei Zhang
Abstract: The risk premium in the US stock market has fallen far below its historic level, which Shiller (2000) attributes to a bubble driven by psychological factors. As an alternative explanation, we point out that the observed risk premium may be reduced by one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk. By allowing for partial credibility and state dependent risk aversion, we show that this ?insurance? ? referred to as the Greenspan put ? is consistent with the observation that implied volatility rises as the market falls. Our bubble, like Shiller?s, involves market psychology: but what we describe is not so much ?irrational exuberance? as exaggerated faith in the stabilising power of Mr. Greenspan.
Keywords: asset bubble; Greenspan put; monetary policy; risk premium
JEL Codes: D84; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Federal Reserve's one-sided intervention policy (E52) | belief among investors that they are insured against downside risk (G41) |
| belief among investors that they are insured against downside risk (G41) | reduction in the risk premium in the stock market (G17) |
| Federal Reserve's one-sided intervention policy (E52) | reduction in the risk premium in the stock market (G17) |
| belief among investors that they are insured against downside risk (G41) | bubble-like effect in stock prices (E32) |
| Federal Reserve's one-sided intervention policy (E52) | bubble-like effect in stock prices (E32) |