Each of these elements is now discussed in tum, Risk-foe rale The risk-free rate is an estimate of the underlying cost of riskless borrowing in an economy. It is normal to proxy this rate through the use o! government borrowing rates. Of course, government borrowing rates are not riskless - apart from the general risk of the government there is risk of unexpected inflation affecting nominal bonds. Whilst index-linked bonds are a partial solution to this there use is limited across Europe. Government bonds are, however, normally the least risky asset in an economy and, as such, typically the relevant benchmark against which riskier assets are measured.
The choice ot the appropriate government security to act as the risk-free rate depends on: • the availability of different maturities; • the frequency of trades and size of the bonds; • whether nominal or index-linked bonds are issued; and • the time horizon of the investment.
For countries with a significant number of government bonds there are indices of specific maturity developed - say a constant five year or 10 year maturity. With these indices individual bonds are included while their maturity is within the band of the constant maturity and then dropped once it is outside the band (so the five year bond may include bonds with remaining matūrines between three and a half and six and a half years). We have focused on these son of Bloomberg index but also considered some individual bonds, As discussed later, we use several different maturities to provide a range of time horizons for the WACC calculation.
iiqnityl market risk premium While the principle behind the LcommasuperiorRP or MRP (henceforth referred to solely as the MRP) is simple - as noted above, it is the additional return demanded by investors to hold the whole "risky" portfolio in a country — the measurement has proven a subject of intense academic debate. The basic problem arises trom the observed values for the MRP, which are measured bv comparing the returns on the market with returns on risk-free assets.
Figure 3.1 below summarises selected regulator)- decisions and our view of the broad consensus regarding the MRP over time. In the 1990s, worldwide evidence pointed to a MRP in the broad range of c4% to 7%, or even as high as 9%. Many regulator)- decisions on the WACC in the late 1980s and early 1990s used these figures.3 II SÉRIE-B — NÚMERO 226
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