Internal consistency of risk free rate and MRP in the CAPM

(or higher) equity premium, thus leaving the central estimate of the cost of
equity capital unaffected. 1 (Emphasis added)
6. The negative relationship between the risk free rate and the market risk premium is
factored into regulatory regimes in the UK and the US.
7. In Australia this negative relationship is well illustrated by Figure 11 of this report,
which is reproduced below. The figure shows a time series for the equity risk premium
for Australian publicly listed equities estimated using the AMP method as described in
the body of this report (and as previously relied upon by the AER to support its
estimate of the MRP) against the 10 year yield on Commonwealth Government
Securities (CGS).
8. The figure shows that there is a clear negative relationship between the equity risk
premium and the yield on 10 year CGS: The equity risk premium is lowest when CGS
yields are highest and highest when CGS yields are lowest (in early 2009 and once
more at the time of writing in early 2012).
9. Moreover, this negative relationship can be clearly discerned even when CGS yields
are at less extreme levels. For example, between 1998 and 2005, peaks in the MRP
are generally coincident with troughs in CGS yields (in late 1998, 2003 and 2005),
whilst peaks in CGS yields occur with troughs in the MRP series (in 2000, in 2002 and
again in 2004).
1 Smithers and Co, A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K., A
report commissioned by the U.K. economic regulators and the Office of Fair Trading. (2003), p. 49
Competition Economists Group
www.CEG-AP.COM
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