The RPF Model for Calculating the Equity Market Risk Premium and Explaining the Value of the S&P with Two Variables

This article presents a remarkably simple Risk Premium Factor Model that explains S&P Index levels from 1960 to the present with considerable accuracy using only the risk-free rate, S&P 500 operating earnings, and a small number of simplifying assumptions. Instead of a fixed Equity Risk Premium, the model employs a new approach for estimating the Equity Risk Premium called the Risk Premium Factor, or "RPF." The RPF, which is consistent with the theory of loss aversion associated with Kahneman and Tversky's "prospect theory," calculates the general market risk premium as a direct function of the level of interest rates-that is, falling when interest rates are low and rising when they are high-thereby amplifying the effects of changes in interest rates on stock prices. The RFP model suggests that the decline in U.S. risk-free rates since the early 1980s has accounted for more than half of the growth in the S&P 500 since then. Copyright Copyright (c) 2010 Morgan Stanley.