The Equity Fear Premium and Daily Comovements of the S&P 500 E/P Ratio and Treasury Yields Before and During the 2007 Financial Crisis

50 Pages Posted: 24 Aug 2010 Last revised: 2 Jul 2011

Christophe Faugère

Kedge Business School Bordeaux

Date Written: August 23, 2010

Abstract

The daily S&P 500 forward earnings yield (E/P ratio) is strongly negatively correlated with daily Treasury yields of all maturities during the 2007 financial crisis, which is a reversal from the relation that prevailed before the crisis. To explain this pattern reversal, I introduce a new risk measure called the Total Fear Premium that accounts for flight-to-safety and flight-to-liquidity behavior. The Total Fear Premium “mimics” the VIX during the financial crisis. Once the basic GARCH formulation modeling the interaction between the earnings yield and Treasury yields is augmented with the Total Fear Premium, the relation between the earnings yield and short-term Treasury yields becomes significantly positive, in line with Fama’s (1975) view that short-term yields are good proxies for expected inflation. Two by-products of this analysis are: 1) a new risk premium measure associated with flight-to-liquidity and 2) a new way to measure the inflation risk premium on a daily basis.

Keywords: Comovement, Fear Premium, Flight-to-safety, Flight-to-liquidity, S&P 500 Earnings Yield, Fed Model, Required Yield, Treasury Yields, Federal Funds Rate, Target, Inflation Risk Premium

JEL Classification: G12

Suggested Citation

Faugère, Christophe, The Equity Fear Premium and Daily Comovements of the S&P 500 E/P Ratio and Treasury Yields Before and During the 2007 Financial Crisis (August 23, 2010). 23rd Australasian Finance and Banking Conference 2010 Paper. Available at SSRN: https://ssrn.com/abstract=1664113 or http://dx.doi.org/10.2139/ssrn.1664113

Christophe Faugère (Contact Author)

Kedge Business School Bordeaux ( email )

680 Cours de la Liberation
Bordeaux, Aquitaine 33405
France

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