Internal consistency of risk free rate and MRP in the CAPM

ating one notch to the equivalent of AA-, bringing it into line with S&P’s rating,
which had been downgraded earlier in the year. Despite rating changes, longterm
government bond yields in the United States and Japan have fallen
since the start of August as risk aversion has grown. (Emphasis added)
104. In the same document the RBA reiterates the fact that the falling CGS yields in the
second half of 2011 were contemporaneous with heightened risk aversion: 29
Risk aversion and volatility in global financial markets have increased
sharply since the start of August (Graph 1.1) …. Across many countries,
prices of shares and other risk assets have declined sharply since early August.
Bank and insurer share prices have been particularly affected, falling by more
than 15 per cent in most countries, to be around their lowest levels since early
2009 (Graph 1.2)…
This current episode of risk aversion and volatility follows a number of
periods of heightened market turbulence over the past couple of years.
These periodic events indicate that financial market participants remain sensitive
to bad news following the experience of 2008–09. While the latest bout of market
uncertainty is not on the scale of 2008–09, it is unclear at this stage whether it
will be another temporary episode or whether it is foreshadowing a more serious
market dislocation. (Emphasis added)
105. It is important to understand that it would be an error to argue, based on the last
sentence of this quote, that the regulatory MRP should not be increased to reflect
heightened uncertainty/risk aversion because this may only be temporary. Even if we
know that the heightened risk aversion is temporary (which we do not), if we are using
prevailing CGS as our estimate of the risk free rate, we must still reflect even
temporarily higher MRP levels in our cost of equity estimate. To do otherwise would
be to pass through a temporarily lower CGS yield that is the ‘other side of the coin’ of
temporarily higher risk aversion.
5.2. Specific supply and demand conditions in the CGS market
106. Figure 10 and Figure 11 above clearly illustrate the negative relationship between risk
premiums and the risk free rate that is driven by the flight to safety of CGS in periods
of heightened risk aversion. However, there is good reason to believe that there are
current aspects of the supply and demand dynamics for Australian CGS that will tend
to depress CGS yields, and raise risk premiums, even in periods of ‘normal’ market
conditions. Specifically, the experience of recent years is likely the supply of CGS is
small relative to the size of the Australian economy and:
29 Ibid, pp. 5-6
� international events have seen a significant increase in demand for CGS by
foreign investors; and
Competition Economists Group
www.CEG-AP.COM
28