_3_ instance, rather than at local rates unless their government's bonds are quoted in US dollars and the government is widely believed to repay all current and future debts.

**The equity risk premium** **_(rm_** - _rf)._ The second standard measure in the estimation relates to the level of additional return that is required to persuade investors to hold equities in preference to the risk free instrument. There is much controversy surrounding the calculation of this element-recent UK regulatory experience has focused on figures between 4% and 6% while some parts of traditional finance theory suggest orders of magnitude of, at most, 2%. An alternative is to measure the historical spread between the yield on a government security and that of a general market index. In the US, this could be the spread between the yield on a 1 year Treasury Bill and the returns on the 500 Standard & Poor index. Evidence has suggested that figures between 8% and 10% are found when this approach is adopted, both in the US and the UK. This may reflect a world-wide premium, to which a country specific premium may have to be added. However, determining an exact figure from this premium is impossible and so range should be employed. For most countries, using between 5% and 8% should establish a credible set of boundaries.

**The equity beta** (fi,). The final, and only company specific, element to be established is that of the equity beta. This measures the relative riskiness of the company's equity compared to the market as a whole. To accurately measure the equity beta it is normal to use at least three years worth of daily share price information and preferably five years worth-especially if monthly data is used.<sup>4</sup> Since many of the projects that will be considered for privatization in less developed countries will be provided either by unquoted companies or international firms, it will not be possible to establish a specific beta value for the project from the available information. The next section is concerned with estimating this value when sufficient information is not available.5

# 2.2 MEASURES OF MARKET **RISK**

Although the CAPM is based around the use of the equity beta as described above, when determining the appropriate allowed rate of return it is important to start from the basic building block of an asset beta since this allows:

- an evaluation of the impact of different gearing levels; and

- a comparison of underlying risk across companies.

While the theory underlying beta calculations is now increasingly well understood among regulators, the practical needs of the estimation of a beta value are not yet that well appreciated among regulatory practitioners. The broad steps are:

1. establish an equity beta value;

2. determine the level of gearing for the company; and 3. establish an asset beta value.

- 4 There is a large academic literature on the subject of how the beta value should be measured. This is surveyed in an annex to Regulatory Structure and Risk and Infrastructure Firms: An International Comparison by Alexander, Mayer and Weeds, Policy Research Working Paper 1698,1996, World Bank.

- 5 For a more general discussion of the techniques described here see Alexander, OXERA, 1995 or Industry Commission (Australia), 1996.