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Moral Hazard and the US Stock Market: The Idea of a 'Greenspan Put'

  • Miller, Marcus
  • Weller, Paul
  • Zhang, Lei

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3041.

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Date of creation: Nov 2001
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Handle: RePEc:cpr:ceprdp:3041
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  1. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  2. Schwert, G William, 1981. "The Adjustment of Stock Prices to Information about Inflation," Journal of Finance, American Finance Association, vol. 36(1), pages 15-29, March.
  3. John Y. Campbell, 1998. "Asset Prices, Consumption, and the Business Cycle," NBER Working Papers 6485, National Bureau of Economic Research, Inc.
  4. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
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  6. Firth, Michael, 1979. "The Relationship between Stock Market Returns and Rates of Inflation," Journal of Finance, American Finance Association, vol. 34(3), pages 743-49, June.
  7. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
  8. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  9. Hali J. Edison & Pongsak Luangaram & Marcus Miller, 1998. "Asset bubbles, domino effects and 'lifeboats': elements of the East Asian crisis," International Finance Discussion Papers 606, Board of Governors of the Federal Reserve System (U.S.).
  10. Lintner, John, 1975. "Inflation and Security Returns," Journal of Finance, American Finance Association, vol. 30(2), pages 259-80, May.
  11. Stephen G. Cecchetti & Anil K Kashyap, 1995. "International Cycles," NBER Working Papers 5310, National Bureau of Economic Research, Inc.
  12. Bates, David S, 1991. " The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 1009-44, July.
  13. Marcus Miller & Paul Weller & Lei Zhang, 2000. "Moral Hazard and the US Stock Market: Has Mr. Greenspan Created a Bubble?," Econometric Society World Congress 2000 Contributed Papers 1902, Econometric Society.
  14. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-65, September.
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