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