Expected cost of equity and the expected risk premium in the UK

Abstract

In this paper, it is argued that previous estimates of the expected cost of equity and the expected arithmetic risk premium in the UK show a degree of upward bias. Given the importance of the risk premium in regulatory cost of capital in the UK, this has important policy implications. There are three reasons why previous estimates could be upward biased. The first two arise from the comparison of estimates of the realised returns on Government Bond (“Gilt”) to realised and expected returns on equities. These estimates are frequently used to infer a risk premium relative to either the current yield on index-linked gilts or an “adjusted” current yield measure. This is incorrect on two counts; first, inconsistent estimates of the risk free rate are implied on the right hand side of the CAPM (Jenkinson, 1993); second, they compare realised returns from a bond which carried inflation risk with realised and expected returns from equities which may be expected to have at least some protection from inflation risk. The third, and most important, source of bias arises from uplifts to expected returns. If markets exhibit “excess volatility” (Shiller 1981), or if part of the historical return arises because of revisions to expected future cash flows, then estimates of variance derived from historical returns or price growth must be used with great care when uplifting average expected returns to derive simple discount rates. Adjusting expected returns for the effect of such biases leads to lower expected cost of equity and risk premia than those that are typically quoted.