Internal consistency of risk free rate and MRP in the CAPM

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Table of Contents Executive summary i Volatility in CGS and AER idiosyncratic application of the CAPM i Negative relationship between CGS yields and risk premiums i RBA views on heightened risk premiums and scarcity premiums for CGS v AER methodology not consistent with NGR 87(1) vi Alternatives to the AER methodology vi Conclusion viii 1. Introduction 1 2. Movements in the risk free rate and AER methodology 4 2.1. CGS yields are at historical low 4 2.2. AER methodology will cause the cost of equity to be at a historically low level 5 3. Movements in the risk free rate and the cost of equity 7 3.1. Risk premiums are not constant 7 3.2. MRP will often move in the opposite direct into the risk free rate 8 4. Movements in the risk free rate and the required return on other assets 10 4.1. Risk premiums on low risk assets 11 4.2. Risk premiums on high risk bonds 12 4.3. Risk premiums on equities 15 4.4. Risk premiums on utility equities 18 5. Why required returns on riskier assets are not falling in line with CGS yields 20 5.1. Flight from risky to safe assets 20 5.2. Specific supply and demand conditions in the CGS market 28 6. Regulatory precedent for dealing with volatility in risk free rates 33 6.1. Australian Competition Tribunal 33 6.2. UK regulators 35 6.3. US regulators 36 6.4. Australian regulatory practice 38 7. How should the cost of equity be estimated 41 7.1. Methodology i) 42 Competition Economists Group www.CEG-AP.COM
7.2. Methodology ii) 43 7.3. Methodology iii) 44 7.4. Methodology iv) 47 7.5. Summary of results from different methodologies 47 8. Conclusion 49 Appendix A. Assumptions used in DGM modelling 50 Competition Economists Group www.CEG-AP.COM
Page 1: Internal consistency of risk free r
Page 5 and 6: Table of Tables Table 1: AAA to BBB
Page 7 and 8: (or higher) equity premium, thus le
Page 9 and 10: Total cost of equity (AMP method) S
Page 11 and 12: 19. Material increases in demand fo
Page 13 and 14: Conclusion 23. I consider that the
Page 15 and 16: 24(5) A reference tariff should all
Page 17 and 18: 2. Movements in the risk free rate
Page 19 and 20: � sets the market risk premium pr
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Page 23 and 24: 4. Movements in the risk free rate
Page 25 and 26: Figure 4: Spread between AAA corpor
Page 27 and 28: Table 1: AAA to BBB spreads at 1 ye
Page 29 and 30: 64. It is also common practice to u
Page 31 and 32: Figure 8: AMP method estimate of Ro
Page 33 and 34: 5. Why required returns on riskier
Page 35 and 36: iii. Indeed, the increase in risk p
Page 37 and 38: Figure 10: 10 year risk premiums on
Page 39 and 40: Figure 11: Risk premiums on listed
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Table 4: Summary of results from ea
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Appendix A. Assumptions used in DGM
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Internal consistency of risk free rate and MRP in the CAPM

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