Internal consistency of risk free rate and MRP in the CAPM

Conclusion
23. I consider that the overwhelming empirical and contextual evidence suggests that the
observed low yields on Commonwealth Government Securities (CGS) are as a result
of a general flight to safety by investors exacerbating a pre-existing scarcity premium.
The current low yields do not signal that investors perceive the economic environment
as being less risky. Indeed, the opposite is the case and the fall in CGS yields is
symptomatic of greater perceived risks by investors in many classes of assets. The
current historically low CGS yields are not a sound basis for concluding that required
returns on risky assets are also at historically low levels.
24. However, application of the AER’s methodology leads to changes in CGS yields being
passed, one-for-one, into a lower cost of equity, whilst the MRP and equity beta are
estimated on a historical basis. Applied at the end of December 2011, the AER’s
methodology would estimate a cost of equity of 8.6%, whereas forward-looking
measures of the cost of equity that I survey in this report range from 10.6% to 14.6%.
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