Alternative measures of the Federal Reserve banks' cost of equity capital
AbstractThe Monetary Control Act of 1980 requires the Federal Reserve System to provide payment services to depository institutions through the twelve Federal Reserve Banks at prices that fully reflect the costs a private-sector provider would incur, including a cost of equity capital (COE). Although Fama and French (1997) conclude that COE estimates are “woefully” and “unavoidably” imprecise, the Reserve Banks require such an estimate every year. We examine several COE estimates based on the Capital Asset Pricing Model (CAPM) and compare them using econometric and materiality criteria. Our results suggest that the benchmark CAPM applied to a large peer group of competing firms provides a COE estimate that is not clearly improved upon by using a narrow peer group, introducing additional factors into the model, or taking account of additional firm-level data, such as leverage and line-of-business concentration. Thus, a standard implementation of the benchmark CAPM provides a reasonable COE estimate, which is needed to impute costs and set prices for the Reserve Banks’ payments business.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Boston in its series Public Policy Discussion Paper with number 05-2.
Date of creation: 2005
Date of revision:
Other versions of this item:
- Barnes, Michelle L. & Lopez, Jose A., 2006. "Alternative measures of the Federal Reserve Banks' cost of equity capital," Journal of Banking & Finance, Elsevier, vol. 30(6), pages 1687-1711, June.
- Michelle L. Barnes & Jose Lopez, 2005. "Alternative measures of the Federal Reserve banks' cost of equity capital," Working Paper Series 2005-06, Federal Reserve Bank of San Francisco.
- NEP-ALL-2006-01-01 (All new papers)
- NEP-CBA-2006-01-01 (Central Banking)
- NEP-FMK-2006-01-01 (Financial Markets)
- NEP-MAC-2006-01-01 (Macroeconomics)
- NEP-MON-2006-01-01 (Monetary Economics)
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