The CAPM Market Risk Premium is Forward-Looking

Deck: 

Don’t Settle for A Historical Risk Premium

Fortnightly Magazine - December 2022
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The Capital Asset Pricing Model (CAPM) is widely used to estimate the cost of equity component of a firm's cost of capital in public utility rate proceedings, corporate finance, and asset allocation. The CAPM posits that the required return of a company's stock is equal to the risk-free rate (often proxied by a U.S. Treasury security yield), plus the product of that company's beta (a measure of the company stock's volatility relative to the market) and the expected risk premium for the market (a diversified portfolio of all assets often proxied by the S&P 500 Index).

The expected return on the market above the risk-free rate of return is the market risk premium. An expected return is, by definition, forward looking. Yet, historical (realized) stock returns are often used to estimate the market risk premium even though it is unlikely to reflect return expectations of investors and can lead to inaccurate results.

This is a critical issue in public utility rate setting, where determination of a just and reasonable rate of return on the utility's used and useful property is often highly contested, as one basis point more in the authorized cost of capital can result in millions of dollars collected from customers.

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