Estimating Cost of Equity for WACC: CAPM Parameter Selection in the Hong Kong Market

The Hong Kong Monetary Authority’s (HKMA) December 2024 Supervisory Policy Manual module on interest rate risk in the banking book (IRRBB) and the Securities and Futures Commission’s (SFC) ongoing consultation on the Code of Conduct for sponsors (SFC Code, para. 17, 2024 revision) have sharpened the focus on discount rate methodology in valuation exercises. For CFOs of Main Board issuers and their financial advisors, the weighted average cost of capital (WACC) remains the standard tool for impairment testing under HKAS 36, business combination purchase price allocation, and project appraisal. Yet the Capital Asset Pricing Model (CAPM) — the most common method for estimating the cost of equity component — is increasingly subject to scrutiny over parameter selection. The risk-free rate, equity risk premium (ERP), and beta estimation each carry material implications for the final discount rate. A 50-basis-point shift in the cost of equity can alter a HK$1 billion impairment test result by HK$15–20 million on a discounted cash flow (DCF) with a 10-year horizon. This article examines the specific parameter choices facing Hong Kong-listed companies in 2025, drawing on HKEX Listing Rules, SFC guidance, and observable market data.

The Risk-Free Rate: From HIBOR to the 10-Year HKDGB

The selection of the risk-free rate (Rf) in a Hong Kong context requires reconciling a local-currency liability with a global pricing framework. The SFC’s 2023 consultation on the Code of Conduct for sponsors (SFC Code, para. 17.4) explicitly states that valuation assumptions must be “reasonable and supportable,” with the risk-free rate being a primary input.

The 10-year HKD Government Bond yield as the benchmark. As of 31 March 2025, the 10-year HKD Government Bond (HKDGB) yield stood at 3.87%, according to HKMA data. This is the standard reference for Hong Kong dollar-denominated DCF models, consistent with practice in the U.S. (10-year UST) and Europe (10-year Bund). The HKMA’s Exchange Fund Investment Portfolio, which holds HKDGBs, provides a deep and liquid market, with average daily turnover of approximately HK$4.2 billion in Q1 2025. For issuers with a functional currency other than HKD, the appropriate local-currency government bond yield should be used — for example, the 10-year China Government Bond (CGB) yield at 2.31% for PRC-incorporated issuers.

The term premium adjustment. A common error is using the 10-year yield without adjusting for the projection period. For a 5-year DCF, the 5-year HKDGB yield (3.45% as of 31 March 2025) is more appropriate. The HKMA’s 2024 annual report notes that the yield curve has flattened, with the 2s10s spread narrowing to 12 bps in Q4 2024 from 45 bps in Q1 2023. This flattening reduces the term premium adjustment’s materiality but does not eliminate it. A 20-bps mismatch between the risk-free rate and the projection horizon can compound to a 0.5% error in the terminal value calculation for a 10-year model.

The HIBOR swap curve as an alternative. For shorter-duration projects (3–5 years), some practitioners use the HKD Overnight Index Swap (HONIA) curve, referencing the HKMA’s HONIA fixings. The 5-year HONIA swap rate was 3.62% as of 31 March 2025, 17 bps above the 5-year HKDGB yield. This spread reflects the credit risk premium embedded in the banking system compared to sovereign debt. The SFC’s 2024 thematic review of valuation reports (SFC, 2024) noted that 23% of reviewed reports used HIBOR-based curves without adequate justification, leading to higher discount rates and potentially overstated impairment charges.

The Equity Risk Premium: Hong Kong vs. Global Benchmarks

The equity risk premium (ERP) is the most judgmental parameter in the CAPM, and its selection in Hong Kong requires navigating between global academic estimates and local market conditions.

The Damodaran approach and its limitations. Professor Aswath Damodaran’s implied ERP for Hong Kong as of January 2025 was 5.38%, derived from the Hang Seng Index (HSI) dividend yield and earnings growth projections. This is 47 bps below the U.S. implied ERP of 5.85% and 112 bps above the China A-share ERP of 4.26%. However, the Damodaran methodology relies on the HSI’s aggregate dividend payout ratio, which has been distorted by the concentration of index weight in financials (approximately 45% of HSI market cap as of Q1 2025) and the special dividends from companies like HSBC Holdings (SEHK: 5). For non-financial issuers, a sector-specific ERP may be more appropriate.

The historical ERP for Hong Kong. The historical arithmetic mean ERP for the HSI versus the 10-year HKDGB from 1990 to 2024 was 6.2%, according to the HKEX’s 2024 Market Statistics report. The geometric mean was 4.8%, reflecting the compounding effect of negative returns during the 1997 Asian Financial Crisis, 2008 Global Financial Crisis, and 2020 COVID-19 pandemic. The SFC’s 2023 consultation (SFC Code, para. 17.5) does not prescribe a specific ERP but requires that the chosen ERP be “consistent with the issuer’s business risk profile and the valuation date.” A family office or sponsor using the 6.2% historical arithmetic mean for a stable utility company (e.g., CLP Holdings, SEHK: 2) would likely overstate the cost of equity by 150–200 bps, as the HSI’s historical volatility includes sectors with higher systematic risk.

The country risk premium adjustment. For Hong Kong-incorporated issuers with significant PRC operations, the ERP must incorporate a country risk premium (CRP). The HKMA’s 2024 Financial Stability Report notes that Hong Kong’s sovereign credit default swap (CDS) spread averaged 28 bps in Q1 2025, compared to 45 bps for China. Using the Moody’s Aa3 rating for Hong Kong (stable outlook, March 2025) and the Baa1 rating for China (negative outlook, March 2025), the implied CRP differential is approximately 1.2%. The SFC’s 2024 thematic review found that 35% of valuation reports for Hong Kong-listed companies with PRC subsidiaries failed to apply a CRP, resulting in an understated cost of equity by 80–120 bps.

Beta Estimation: The Hong Kong Market Microstructure

Beta estimation in Hong Kong presents unique challenges due to thin trading, index concentration, and the prevalence of cross-border listings.

Choice of market index. The standard benchmark is the Hang Seng Index (HSI), but its composition — 82 constituents as of March 2025, heavily weighted toward financials (45%), properties (12%), and utilities (8%) — means it is not a pure market portfolio. For technology or healthcare companies listed on the Main Board, the Hang Seng Tech Index (HSTECH) may be more appropriate. The 5-year beta for Tencent Holdings (SEHK: 700) against the HSI is 1.12, but against the HSTECH it is 0.98, reflecting the tech index’s higher volatility. The HKEX Listing Rules (Main Board Rule 8.05) require a minimum market capitalisation of HK$500 million for Main Board listings, but do not mandate a specific beta estimation methodology. The SFC’s 2023 consultation (SFC Code, para. 17.6) recommends using a “relevant and widely recognised index” and documenting the rationale.

Estimation period and frequency. The standard practice is 5 years of monthly returns, consistent with Bloomberg’s default setting. For Hong Kong-listed companies, a shorter window (2–3 years) may be justified for companies that have undergone significant corporate actions (e.g., spin-offs, rights issues) or industry disruption. The 3-year monthly beta for AIA Group (SEHK: 1299) is 1.05, compared to the 5-year beta of 0.98, reflecting the post-COVID recovery in Asian insurance markets. Daily return data introduces noise from the Hong Kong market’s 0.5% tick size for stocks above HK$100 and the 1% tick size for stocks below HK$10 (HKEX Trading Rules, Schedule 2). A 5-year daily beta for a HK$5 stock like SITC International (SEHK: 1308) would have a standard error of 0.15, compared to 0.08 for monthly data.

Adjusting for thin trading and non-synchronous data. Approximately 30% of Main Board stocks have an average daily turnover below HK$10 million (HKEX, 2024 Market Statistics). For these stocks, the Scholes-Williams (1977) or Dimson (1979) adjustment is necessary to correct for thin trading bias. The 5-year monthly beta for a small-cap property developer like K. Wah International (SEHK: 173) is 0.85 using ordinary least squares (OLS), but 1.12 under the Dimson adjustment with one lead and one lag. The SFC’s 2024 thematic review flagged thin trading adjustments as a “common deficiency” in valuation reports, with 18% of reviewed reports using unadjusted OLS betas for stocks with turnover below HK$5 million per day.

The Cost of Debt and Capital Structure Interaction

The cost of equity does not operate in isolation; it interacts with the cost of debt and the target capital structure in the WACC calculation.

The cost of debt for Hong Kong issuers. The pre-tax cost of debt is typically estimated using the yield to maturity on the issuer’s outstanding bonds or, for unrated companies, the HKMA’s corporate bond yield curve. As of 31 March 2025, the yield on the HSBC Holdings 3.5% 2028 bond was 4.12%, implying a credit spread of 67 bps over the 5-year HKDGB. For a Baa1-rated Hong Kong utility like CLP Holdings, the 5-year credit spread was 52 bps. The SFC’s 2023 consultation (SFC Code, para. 17.7) requires that the cost of debt reflect the issuer’s “actual or estimated borrowing costs” and be “consistent with the capital structure assumption.”

The capital structure assumption. The HKEX Listing Rules (Main Board Rule 8.10) require disclosure of the gearing ratio (total debt to total equity) in annual reports. As of 31 December 2024, the median gearing ratio for Hang Seng Index constituents was 28.4% (HKEX, 2024 Annual Report Analysis). For a WACC calculation, the target capital structure should be used, not the current book value. The Modigliani-Miller theorem (1958) suggests that the cost of equity increases with leverage, and this must be captured through the unlevering and relevering of beta. The Hamada equation (1972) with a Hong Kong corporate tax rate of 16.5% (Inland Revenue Ordinance, Cap. 112) yields a levered beta of 1.12 for a company with a 30% debt-to-equity ratio and an unlevered beta of 0.95.

Actionable Takeaways

1. Use the 10-year HKD Government Bond yield (3.87% as of 31 March 2025) as the risk-free rate for HKD-denominated DCFs, with a term premium adjustment for projection periods shorter than 10 years.
2. Select the equity risk premium based on the issuer’s sector and geographic exposure, applying a country risk premium of 80–120 bps for Hong Kong-listed companies with significant PRC operations.
3. Estimate beta using 5 years of monthly returns against the Hang Seng Index, with the Scholes-Williams or Dimson adjustment for stocks with average daily turnover below HK$10 million.
4. Document all parameter choices in the valuation report, referencing the SFC Code of Conduct for sponsors (para. 17) and the HKMA’s 2024 Financial Stability Report.
5. Reconcile the cost of equity with the cost of debt and target capital structure using the Hamada equation, applying Hong Kong’s 16.5% corporate tax rate.