London 25 September 2008 Measuring the Risk Free Rate in the UK Regulatory Context Water UK Cost of...
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Transcript of London 25 September 2008 Measuring the Risk Free Rate in the UK Regulatory Context Water UK Cost of...
London
25 September 2008
Measuring the Risk Free Rate in the UK Regulatory Context
Water UK Cost of Capital Seminar 2008
Dr Richard HernTomas Haug
2
Overview
1. The Real Risk Free Rate (RFR) in the CAPM
2. Recent UK Regulatory Decisions on RFR
3. Why UK Index Linked Gilts no longer provide good
evidence on RFR
4. Evidence on RFR from the UK SWAP market Key points
5. International Evidence on RFR
3
Defining the Risk Free Rate in the CAPM
Under the CAPM framework, the cost of equity can be broken into two components
– the expected RFR
– the expected risk premium (=expected beta * expected market risk premium)
UK Regulators have traditionally estimated the expected RFR using historical data on Index Linked Gilts (ILGs)
– most regulators have used long maturity bonds to reflect utility asset lives
4
Recent UK Decisions Can No Longer be Justified Under ILG Evidence
UK RFR decisions stabilised at 2.5% in recent years, despite a downward trend in ILG yields
CAA
ORR
Ofgem Ofgem
CAA ORR
Ofgem
Ofwat
CAA Postcomm
Ofreg
OfgemOfgemOfgemCAA
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
Jan-0
0
Aug-0
0
Apr-0
1
Nov-0
1
Jul-0
2
Feb-03
Oct-03
May-
04
Jan-0
5
Sep-0
5
Apr-0
6
Dec-0
6
Jul-0
7
Mar-0
8
Oct-08
ILG spot yield(5Y Maturity)
ILG spot yield(20Y Maturity)
5
Forward rate Aug-11 5 Year 10 Year 30 Year 50 Year
Spot rate 29-8-2008 1.27 1.34 0.98 0.46 0.34August 2008 1.58 1.57 1.17 0.53 0.36Last 3 months 1.69 1.61 1.27 0.61 0.39Last 6 months 1.54 1.42 1.24 0.69 0.47Last year 1.69 1.60 1.38 0.80 0.61Last 3 years -- 1.83 1.57 0.93 0.77Last 5 years -- 1.82 1.70 -- --Last 10 years -- 2.11 1.97 -- --Source: Bank of England data.
Latest Data on UK ILGs Show Numbers Significantly Below 2.5%
Yields on long dated UK ILGs (> 10 years) are currently less than 1% and less than 2% over all historical time periods
6
Comparing Measures of the RFR Across Markets
Data sourced from US Treasury, Agence France Tresor, Bundesbank, Bank of England and Consensus Economics
UK ILGs yields
0%
1%
2%
3%
4%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
5 yr 7 yr 10 yr 20 yr
US TIPS yields
0%
1%
2%
3%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
5 yr 7 yr 10 yr 20 yr
French OATI yields
0%
1%
2%
3%
4%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
5 yr 7 yr 10 yr 20 yr
German Bunds adjusted for Inflation Expectations
0%
1%
2%
3%
4%
5%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
5 yr 7 yr 10 yr 20 yr
UK yields on 20Y ILGs trade currently below 0.7%. This compares to real yields of 1.8% in France, 2.1% in the US and 2.8% in Germany
7
Actuarial Requirements Have Depressed UK Gilt Yields Below the True RFR
First noted in 1999:
– “Actuarial & regulatory influences have ensured continued strong demand for ILG’s keeping their yields below the likely true level of real interest rates in the wider economy.” (Bank of England, August 1999)
Impact even stronger in 2008:
– “… strong pension fund demand for inflation-protected bonds has pushed down their yields ...this demand may reflect several regulatory and accounting changes [FRS17, IAS19] over the past few years that have encouraged pension funds to seek to match their liabilities more closely with inflation-linked assets” Bank of England (2008 Q2)
0
10000
20000
30000
40000
50000
60000
70000
Jan-
81
Sep-8
3
Jun-
86
Mar
-89
Dec-9
1
Sep-9
4
Jun-
97
Mar
-00
Nov-0
2
Aug-0
5
May
-08
£ m
illi
on
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
UK Pension FundBalance Sheet Position of ILG
ILG yield20Y Maturity
ILG yields versus UK Pension Fund ILG Balance Sheet Position
Source: Bank of England and ONS
8
Academics Have Proposed Using Swaps as an Alternative Measure of the RFR
Choudhry (2005) states:
– “Government bond markets (…) have experienced low liquidity and supply constraints, leading to inverted curves, causing some commentators to suggest that the government yields have traded below the true risk-free level.”
– “[The] government curve may on occasion be overvalued, whereas the swap curve can be regarded as lying at fair value.”
– “[The] only plausible alternative to the government yield curve in the euro and sterling market appears to be the interest rate swap.”
– “The swap market, however, is now very large and liquid, and does not suffer from illiquidity, even out to long-dated maturities. There are also no supply constraints in the swap market, unlike for (say) long-dated gilts or Treasuries.”
Feldhutter and Lando (2007) state:
– “…the riskless rate is better proxied by the swap rate than the Treasury rate for all maturities.”
Hull, Predescu, and White (2004) estimate a risk-free rate for the US market using swap rates and CDS premiums
– The 5Y Treasury yield lies 60 bps below the ‘true’ risk-free rate
– The 5Y ‘true’ risk-free rate is on average around 10 bps less than the swap rate
9
Estimating the RFR from Swaps Requires Adjusting for Banking Sector Credit Risk
1. Adjusting for credit risk:
– Floating leg of swap is tied to 6-month Libor
– Hence, credit risk in swaps reflects credit risk in 6-month Libor Libor is set by 16 banks with AA rating (or better) Credit risk in Libor is “refreshed” periodically (as low credit banks drop
from Libor panel)
– We use default insurance for banks (CDS) to adjust for interbank credit risk
2. Converting nominal to real yields:
– Swaps are nominal and need to be adjusted for inflation expectations
– Oxford Economic Forecasting (OEF) provide medium-term RPI forecast
Swap Rate = “true RFR” + Credit RiskSwap Rate = “true RFR” + Credit Risk
10
CDS Best Available Market Data to Estimate Credit Risk in Banking Sector
We use data on default insurance, i.e. “Credit Default Swaps” (CDS) to estimate interbank credit risk
We use iTraxx CDS index of 5Y Senior Financials issued in Jun-2004
– Index is highly standardised and rules ensure only most liquid entities are included
– We believe best available market data to measure interbank credit risk
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
2002 2003 2004 2005 2006 2007
No
tio
na
l am
ou
nts
in b
illio
ns
of
US
do
llars
CDS Notional Amount Outsanding
Total Equity Derivatives Outstanding
Source: International Swap and Derivatives AssociationNote: (*) swap data included interest rate swaps, currency swaps and interest rate options
Growth in CDS Market Worldwide Since 2003, CDS notional amount outstanding exceeded total equity derivatives outstanding
Back in Nov-05, S&P stated:
– “The increasing liquidity of the CDS market (…) makes CDS good proxies for cash bonds.”
11
UK US Euro
3 m 0.7% 2.1% 1.8%
1 yr 1.0% 2.0% 1.8%
4 yr 1.3% 2.2% 1.6%
3 m 1.8% 2.4% 2.8%
1 yr 1.8% 2.3% 2.6%
4 yr 1.7% 2.4% 2.2%
3 m 2.6% 2.1% 2.6%
1 yr 2.6% 2.3% 2.5%
4 yr 2.5% 2.7% 2.3%3 m 0.7 - 2.6% 2.1 - 2.4% 1.8 - 2.8%
1 yr 1.0 - 2.6% 2.0 - 2.3% 1.8 - 2.6%
4 yr 1.3 - 2.5% 2.2 - 2.7% 1.6 - 2.3%
Real from Nominal
Swap based real
Range
Note: UK yields based on 20Y maturity; US yields based on 20Y maturity; Euro ILG yields based on French OATI (20Y maturity), real from nominal based on German bunds (20Y maturity) and Euro swaps based on 20Y maturity
Inflation-linked
Evidence on UK Real RFR from Swaps Similar to Other Markets
Real RFR across Markets and Instruments
Swap-based RFR similar across markets in range of 2.1-2.6%
Swap-based RFR in UK similar to gilt yields in other markets
12
Swap-based RFR (real) versus 5Y ILGs
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08
Swap-based real RFR(5Y Maturity)
ILGs (5Y Maturity)
RealSwap-based RFR ILG Yield
5Y Maturity 5Y Maturity DiffJun-08 - Aug-08 2.5% 1.6% 0.8%Sep-07 - Aug-08 2.2% 1.6% 0.7%Jun-04 - Aug-08 2.3% 1.8% 0.4%
13
CC and UK regulatory decision no longer justified using ILGs
UK ILG evidence does not provide good measure for ‘true’ Risk Free Rate
Strong academic support for swaps as basis for RFR
UK Swap-based RFR is ~2.5%, which is in line with CC & regulatory precedent
similar to evidence on RFR from other developed markets
Key Points