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Comparison to the Fed Model > Comparison to the Fed Model - Pg. 29

The Risk Premium Factor Valuation Model 29 ADJUSTED RISK-FREE RATE The model was originally constructed using the 30-year Treasury as the risk free rate back in 1999 because I believe the 30-year better reflects long-term inflation expectations and risk embodied in equities. From March 2002 through the end of 2005, the 30-year rate was not reported, so I converted my analysis to use the 10-year, which has data going back to the early 1950s. During 2008 to 2011, due to Fed buying (quantitative easing) and some flight to quality, rates on the 10-year became especially depressed. This is evidenced by the spread between the 10-year and 30-year reaching more than 130 bps or 44 percent greater--its largest spread ever. Historically, the average spread was just 20 bps or 4 percent. Since the 30-year yield is also probably depressed by the Fed buying, I have substituted the 30-year yield in most examples for the risk-free rate for 2008 to 2011. This includes most examples in this book, other than the preceding R-squared analysis. (You could make a case for using 96 percent of the 30-year if you believed that the 30-year was fairly priced.) As shown in Table 2.4, the 30-year actually improves the fit of the model when applied during this period. TABLE 2.4 RPF Valuation Model R-Squared Results with 30-year as R f for 2008 to 2011 R-Squared Dataset 1960 to 2008 (Annual) 1986 to September 2009 (Quarterly) January 1986 to September 2009 (Monthly) January 1986 to September 2009 (Daily) Full Dataset 93.8% 86.1% 90.0% 89.7% Excluding Meltdown 96.7% 89.2% 91.9% 90.9% COMPARISON TO THE FED MODEL The RPF Model is not based on the Fed Model. It is similar, but I had not heard of the Fed Model until a few years after I began working on the RPF Model and did not begin to explore it in depth until I began writing this book. While the Fed Model was not an influence on my development of the RPF Model, some discussion is warranted since the models share a common premise--investors expect a return proportionate to the risk-free rate.