An Alternative Method for Assessing the Risk-Free Rate

The Situation

In April 2007, a UK client asked NERA to analyse an estimate of the real risk-free rate by the UK Civil Aviation Authority, which was used to estimate the cost of capital for Heathrow and Gatwick Airports. UK gilt yield evidence that is used by regulators to estimate the risk-free rate has been distorted for many years by the effects of pension fund regulations (such as the Minimum Funding Requirement, FRS17, IAS19 and the Pension Protection Fund) that have led to highly inelastic demand at times of low levels of supply. The effect of these distortions is to depress yields below the true risk-free rate by the amount that pension funds are willing to pay to meet their legal obligations. In addition, so-called "uniqueness premiums" or market technical factors make government bonds attractive to investors and cause prices to increase and hence yields to decrease, for instance when government bonds are accepted as collateral for loans and as margin for positions in futures markets. Evidence of these factors is supported by academic studies that have shown that credit corporate bond spreads are wider than implied by actual default risk.

NERA's Role

A NERA team investigated alternative methods for estimating the risk-free rate, using evidence based on the interest rate swap market as a benchmark for estimating the "true" risk-free rate within a CAPM framework. NERA considered the advantages of swap rates (as opposed to government bond yields) to be: (i) the swap market is highly liquid with narrow bid/ask spreads for a wide range of maturities; (ii) swap rates across different markets are easier to compare, due to the absence of governmental regulation of the swap market; (iii) the supply of swaps is less likely to be distorted by technical market factors; and (iv) swap rates reflect similar low credit risk across countries, which make comparisons more meaningful.

Swap rates are, however, not default-free rates. Swap rates include the credit risk of the banking sector, which is associated with an AA credit rating. However, with the maturing of the Credit Default Swaps (CDS) market, NERA deemed the CDS market to be sufficiently deep to price credit risk adequately. NERA adjusted for the credit risk premium inherent in swap rates in order to derive a clean benchmark measure for the true risk-free rate.

The Result

Using this alternative methodology, NERA estimated that short-term indexed-linked securities in the UK are biased by around 50-60 basis points. This bias in government bond yields is likely to be even higher if medium- to long-term maturity indexed-linked securities are used as the basis for calculating the risk-free rate. NERA's report is now available for download on the Competition Commission's website.