Time-Varying Market Leverage and the Market Risk Premium in New Zealand

This paper applies the Ibbotson and Sinquefield (1976) method and the Lally (2002) method to New Zealand data over the period 1960-2005 in order to estimate the market risk premium (MRP) in two versions of the capital asset pricing model (CAPM). With respect to the standard CAPM, the resulting Ibbotson estimate of the MRP for New Zealand was 6.11%. The resulting Lally estimate of the MRP ranged from 5.52% (in 1970) to 18.40% (in 1990), with an average of 7.95%, and was 6.40% for 2005. With respect to the simplified Brennan-Lally CAPM, the resulting Ibbotson estimate of the MRP for New Zealand was 8.49%. The resulting Lally estimate of the MRP ranged from 7.91% (in 1970) to 20.79% (in 1990), with an average of 10.33%, and was 8.78% for 2005. The Lally and the Ibbotson estimates of the MRP are similar in general. However, when market leverage is unusually high or low, they diverge significantly. In future, practitioners may need to choose between the estimates from the two methods when market leverage goes beyond the normal level.