Internal consistency of risk free rate and MRP in the CAPM

5. Why required returns on riskier assets are not falling in
line with CGS yields
78. The previous section provided an empirical description of the fact that required returns
on other assets have not been falling with the most recent fall in CGS yields – such
that risk premiums (spreads) have been rising. Section 5.1 below section explains
why this has been happening including by reference to the views of other experts such
as the RBA. Section 5.2 of this report also canvasses the RBA’s views on the extent
to which a ‘scarcity premium’ or ‘liquidity premium’ is currently depressing the yield for
CGS and the likely implications for future levels of CGS yields.
5.1. Flight from risky to safe assets
79. The CAPM, or, more precisely, the Sharpe-Lintner version of the CAPM, predicts that
the expected yield on any asset will be determined by the following formula:
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80. This formula describes an investor’s required return on any asset – be that asset debt,
equity or any other asset. The asset’s beta (βi) is a measure of the risk of that asset
relative to the riskiness of the market portfolio. The MRP describes investors’ required
compensation for the risk associated with holding the market portfolio.
81. Investors’ required compensation for the risk associated with any individual asset can
increase for one or both of two reasons:
� the asset’s beta can increase (i.e. the asset’s risk relative to all other risky assets
can increase); or
� the market risk premium can increase.
82. It is AER’s practice to implement the CAPM formula above assuming that the risk free
rate is best proxied by the prevailing yield on 10 year CGS. Given this practice,
internal consistency requires that the MRP be measured relative to the prevailing yield
on CGS.
83. However, the factual analysis of the previous section demonstrates that the dramatic
fall in 10 year CGS yields in late 2011 was not associated with similarly dramatic
reductions in required yields on other assets – be those assets relatively low risk debt
or the relatively high risk listed equity market.
84. The only internally consistent explanation for this evidence is that there has been an
across the board increase in the risk premiums (measured relative to 10 year CGS
yields) that investors require. This need not be because investors are demanding a
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