Internal consistency of risk free rate and MRP in the CAPM

4. Movements in the risk free rate and the required return on
other assets
46. If low CGS yields are simply a reflection of investors accepting a lower return on all
assets (risky and riskless) then the AER’s methodology is reasonable. That is, it is
reasonable to assume that the cost of equity falls one-for-one with the CGS yields with
the equity risk premium remaining constant.
47. However, if CGS yields are falling primarily as a consequence of factors that do not
push down the overall cost of equity, then the AER approach is not valid. An approach
that does not lower the cost of equity by the same amount as it lowers CGS yields is
appropriate.
48. This issue is one that can be resolved by examination of empirical data. If the AER is
correct then the yields on all assets should fall in line with CGS yields. If the AER is
not correct, then the spread (risk premium) between CGS and other assets should
have risen. The evidence summarised in this section clearly demonstrates that the
spread (risk premium) between CGS and other assets has risen, that is, the AER’s
approach is not valid.
49. This section provides a factual assessment of whether risk premium in general have
stayed constant as CGS yields have fallen. An assessment of the reasons why this
might have happened, including the views of other experts such as the RBA, is
provided separately in section 5below.
50. In this section I review the evidence of recent risk premiums for:
� low risk assets including:
Competition Economists Group
www.CEG-AP.COM
- Australian state government debt; and
- AAA fair values as estimated by Bloomberg.
� high risk bonds, using Bloomberg data to examine the change in spreads between
BBB and AAA rated bonds with one year to maturity;
� high risk bonds using Bloomberg data to examine the change in spread to CGS
for AA, A and BBB rated corporate bonds with maturity between 1 and 5 years;
� the equity market, using information about dividend yields to approximate the
forward-looking MRP (ie, the spread between expected equity market returns and
CGS returns); and
� utilities stocks, using the dividend growth model to estimate forward-looking equity
risk premiums on the six predominantly regulated listed Australian utilities.
51. The evidence from all these sources points at trends towards higher risk premiums at
times of lower CGS yields, such as those experienced in early 2009 and at the current
time.
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