The Relationship Between WACC and the Capital Asset Pricing Model: Selecting the Risk-Free Rate and Market Portfolio

The Hong Kong Monetary Authority’s (HKMA) December 2024 Supervisory Policy Manual (SPM) module on “Capital Adequacy for Market Risk” (CA-MR-1) introduced a revised requirement for authorised institutions to calibrate their internal models using a risk-free rate derived from the Hong Kong dollar (HKD) Overnight Index Swap (OIS) curve, effective 1 January 2025. This shift from the previous reliance on Hong Kong Exchange Fund Bills (EFB) yields has direct implications for how corporate finance practitioners estimate the Weighted Average Cost of Capital (WACC) for Hong Kong-listed entities. Simultaneously, the Securities and Futures Commission (SFC) has signalled in its 2025-26 Business Plan a renewed focus on stress-testing assumptions in valuation models used in IPO prospectuses and takeovers, with particular attention to the selection of the market portfolio under the Capital Asset Pricing Model (CAPM). For CFOs and corporate finance advisors, these regulatory updates mean that the textbook assumptions underpinning WACC calculations—specifically the risk-free rate proxy and the market risk premium (MRP) derived from the CAPM—are now subject to heightened scrutiny. A mis-specified risk-free rate can systematically understate or overstate the cost of equity by 50-100 basis points, materially altering capital allocation decisions in a high-interest-rate environment where the HKD 3-month Interbank Offered Rate (HIBOR) has averaged 4.25% over the first half of 2025. This article examines the technical relationship between WACC and CAPM, focusing on the two critical inputs: the risk-free rate and the market portfolio. It provides a framework grounded in Hong Kong market data and regulatory expectations, drawing on the HKMA’s SPM CA-MR-1 (2024), the SFC’s Code on Takeovers and Mergers (Takeovers Code, 2023), and the Hong Kong Institute of Chartered Secretaries (HKICS) guidance on valuation disclosures.

The Structural Link Between WACC and CAPM

WACC represents the blended cost of a firm’s financing, combining the after-tax cost of debt and the cost of equity weighted by their respective market value proportions. The cost of equity, under CAPM, is expressed as ( r_e = r_f + \beta \cdot (r_m - r_f) ), where ( r_f ) is the risk-free rate, ( \beta ) is the equity risk sensitivity to the market, and ( (r_m - r_f) ) is the market risk premium (MRP). The risk-free rate appears twice in this equation—once as the base return and once as the subtrahend in the MRP calculation—meaning any error in its selection compounds through the entire WACC framework.

The Dual Role of the Risk-Free Rate in WACC

In a WACC calculation, the risk-free rate directly determines the cost of equity through CAPM and indirectly influences the cost of debt. For Hong Kong-incorporated issuers, the cost of debt is typically benchmarked against the HKD swap rate or the Hong Kong Interbank Offered Rate (HIBOR) plus a credit spread. The HKMA’s SPM CA-MR-1 (2024) explicitly requires banks to use the HKD OIS curve as the risk-free rate for internal capital models, replacing the risk-free rate derived from EFB yields. This is a material shift: as of 30 June 2025, the 10-year HKD OIS rate stood at 3.82%, compared to the 10-year EFB yield of 3.45%, a 37-basis-point differential. For a company with a debt-to-total-capital ratio of 40%, a 37-bps increase in the risk-free rate—if applied consistently across both debt and equity costs—raises WACC by approximately 15-20 bps, depending on the tax rate and beta.

The SFC’s Takeovers Code (2023), in Schedule 6 on valuation methodologies, does not prescribe a specific risk-free rate but requires that the basis for its selection be “clearly disclosed and justified.” In practice, for Hong Kong-listed Main Board companies, the 10-year HKD OIS rate has become the preferred proxy since the HKMA’s circular, supplanting the 10-year US Treasury yield (which stood at 4.15% as of 30 June 2025) for HKD-denominated cash flows. For cross-border structures—for example, a Cayman Islands-incorporated company with operations in the PRC and a Hong Kong listing—the risk-free rate must match the currency of the cash flows. The SFC’s 2024 consultation paper on “Disclosure of Valuation Assumptions in Listing Documents” (SFC, 2024) reinforced that using a foreign-currency risk-free rate without a documented rationale constitutes a material omission.

The Market Risk Premium as a Derived Input

The MRP is the second critical link between WACC and CAPM. It is not directly observable but is estimated from historical equity returns relative to the risk-free rate. For Hong Kong, the Hang Seng Index (HSI) has a historical arithmetic mean return of approximately 8.7% per annum from 1990 to 2024 (HSI Services Limited data), yielding an MRP of 4.88% against the 10-year HKD OIS rate of 3.82% as of mid-2025. However, using the geometric mean—a common adjustment for long-term projections—reduces this to 4.2%. The choice between arithmetic and geometric means can shift WACC by 30-50 bps for a firm with an equity beta of 1.2. The SFC’s 2023 Code on Takeovers and Mergers (Section 4.2) requires that the MRP assumption in valuation reports be supported by “a reference to an independent and reputable source of market data,” such as the Duff & Phelps (now Kroll) or PwC annual MRP reports. For Hong Kong-listed companies, the PwC “Risk Premiums for Equity Markets” report (2024 edition) suggests an MRP range of 5.0% to 6.5% for the Hong Kong market, depending on the measurement period and methodology.

Selecting the Risk-Free Rate: Hong Kong Market Conventions

The selection of the risk-free rate is the most consequential single input in the CAPM-WACC framework, as it affects both the cost of equity and the cost of debt. For Hong Kong, the choice is not a theoretical exercise but a practical one governed by regulatory guidance and market liquidity.

The Shift from EFB Yields to HKD OIS

Prior to the HKMA’s SPM CA-MR-1 (2024), the standard proxy for the risk-free rate in Hong Kong was the yield on Hong Kong Exchange Fund Bills (EFBs), specifically the 10-year maturity, which was considered risk-free due to the Hong Kong government’s AA+ credit rating (Fitch, 2024). However, the HKMA’s new requirement mandates that authorised institutions use the HKD OIS curve for internal capital models, reflecting the OIS market’s deeper liquidity and its alignment with the risk-free rate definition under Basel III. The OIS rate represents the expected average of the overnight HIBOR over the swap period, stripped of credit risk. As of 30 June 2025, the 5-year HKD OIS rate was 3.55%, while the 5-year EFB yield was 3.28%, a 27-bps gap. For a 10-year horizon, the gap widens to 37 bps.

For corporate finance practitioners, this shift has practical implications. If a company uses the 10-year EFB yield as the risk-free rate in its WACC calculation for a project with HKD-denominated cash flows, while its lenders use the HKD OIS rate to price debt, a mismatch arises. The cost of equity will be understated relative to the cost of debt, potentially leading to a misallocation of capital toward equity-financed projects that appear cheaper than they are. The HKMA’s SPM CA-MR-1 (2024) does not explicitly apply to non-bank corporates, but the SFC’s 2024 consultation paper on valuation disclosures (para 3.7) encourages all regulated entities to align their risk-free rate with the OIS curve for consistency.

Maturity Matching and Currency Denomination

The risk-free rate must match the duration of the cash flows being discounted. For a Hong Kong-listed property developer with a 15-year land bank, using the 10-year HKD OIS rate (3.82%) versus the 5-year rate (3.55%) changes the cost of equity by 27 bps, which, when applied to a beta of 1.1 and an MRP of 5.0%, shifts the cost of equity from 9.32% to 9.62%. The SFC’s Takeovers Code (2023, Schedule 6) requires that the maturity of the risk-free rate be disclosed and justified relative to the project or asset life.

For companies with cross-border cash flows—for example, a BVI-incorporated, Hong Kong-listed company with PRC operations—the risk-free rate must be denominated in the currency of the cash flows. Using the 10-year US Treasury yield (4.15%) for HKD-denominated cash flows without a currency adjustment introduces a systematic error. The HKMA’s SPM CA-MR-1 (2024) explicitly states that the risk-free rate should be “denominated in the same currency as the cash flows” (para 4.2.1). For PRC-renminbi (CNY) cash flows, the 10-year Chinese government bond yield (2.65% as of 30 June 2025) is the appropriate proxy, not the HKD OIS rate. A mismatch of 117 bps between the HKD OIS and CNY government bond yields would, if applied to a 50% equity-financed project, overstate WACC by approximately 40 bps.

Selecting the Market Portfolio: The Hong Kong Equity Market

The market portfolio in CAPM represents the systematic risk of the equity market. In Hong Kong, the choice of market portfolio is complicated by the presence of a dual-listed market (Main Board and GEM), the dominance of PRC-related stocks, and the availability of regional indices.

The Hang Seng Index as the Primary Proxy

The Hang Seng Index (HSI) is the most widely used market portfolio for Hong Kong-listed companies. As of 30 June 2025, the HSI comprised 82 constituent stocks, representing approximately 57% of the total market capitalisation of the Hong Kong Stock Exchange (HKEX, 2025). The historical beta of the HSI relative to itself is 1.0 by definition. For a company with a beta of 1.2, the cost of equity using the HSI-based MRP of 5.0% and a 10-year HKD OIS risk-free rate of 3.82% is 9.82%.

However, the HSI has a significant bias toward financial and property stocks, which constituted 38% and 12% of the index by weight as of 30 June 2025, respectively (HSI Services Limited data). For a technology company listed on the Main Board, using the HSI as the market portfolio may understate the systematic risk because the index does not fully capture the technology sector’s volatility. The SFC’s 2023 Code on Takeovers and Mergers (Section 4.2) allows for the use of an alternative market portfolio, such as the Hang Seng Tech Index (HSTECH), provided the choice is “clearly justified and disclosed.” The HSTECH had a historical volatility of 28% over the 5 years to 2024, compared to the HSI’s 18%, meaning a company with a beta of 1.2 against the HSTECH would have a cost of equity of 10.42% (using the same risk-free rate and MRP), 60 bps higher than using the HSI.

The Role of the MSCI Hong Kong Index and Regional Benchmarks

For companies with significant cross-border exposure, the MSCI Hong Kong Index (which tracks large- and mid-cap Hong Kong-listed stocks) is an alternative. As of 30 June 2025, the MSCI Hong Kong Index had a 12-month trailing dividend yield of 3.8%, compared to the HSI’s 4.1%. The choice between the HSI and MSCI Hong Kong Index changes the beta calculation: for a company with a 0.8 beta against the HSI, the beta against the MSCI Hong Kong Index may be 0.85 due to the different constituent weights. The SFC’s 2024 consultation paper on valuation disclosures (para 4.1) requires that the market portfolio be “representative of the investable universe in which the company operates.” For a Hong Kong-listed company with 70% of its revenue from the PRC, using the MSCI China Index (which includes H-shares, Red Chips, and A-shares) may be more appropriate, though the MSCI China Index had a higher volatility of 22% over the 5 years to 2024, leading to a higher cost of equity.

The HKEX Listing Rules (Main Board, Chapter 11) require that any deviation from the HSI as the market portfolio in a valuation report included in a listing document be justified in the “Basis of Opinion” section. In practice, for IPO valuations, the sponsor typically uses the HSI as the primary market portfolio and then conducts a sensitivity analysis using the MSCI Hong Kong Index or the Hang Seng Composite Index (HSCI) to demonstrate robustness.

Practical Implications for WACC Estimation in Hong Kong

The interplay between the risk-free rate and the market portfolio selection has direct consequences for WACC estimation, particularly in the current high-interest-rate environment. The following section examines how these inputs affect the weighted cost of debt and equity.

The Impact of Risk-Free Rate Selection on the Cost of Debt

The cost of debt in WACC is typically estimated as the risk-free rate plus a credit spread. For a Hong Kong-listed company with a BBB+ credit rating (Fitch, 2025), the credit spread over the 10-year HKD OIS rate is approximately 120 bps, yielding a pre-tax cost of debt of 5.02% (3.82% + 1.20%). Using the 10-year EFB yield (3.45%) instead would give a pre-tax cost of debt of 4.65%, a 37-bps difference. After applying a 16.5% Hong Kong profits tax rate (as of 2025-26), the after-tax cost of debt changes from 4.19% to 3.88%. For a company with a 40% debt-to-total-capital ratio, this 31-bps difference in after-tax cost of debt reduces WACC by approximately 12 bps.

The HKMA’s SPM CA-MR-1 (2024) does not mandate the use of the OIS curve for non-bank corporates, but the SFC’s 2024 consultation paper (para 3.9) suggests that “the risk-free rate used in the cost of debt should be consistent with that used in the cost of equity to avoid internal inconsistency.” In practice, for Hong Kong-listed companies, the 10-year HKD OIS rate has become the de facto standard for both debt and equity since the HKMA’s circular.

Sensitivity Analysis and Regulatory Expectations

The SFC’s 2023 Code on Takeovers and Mergers (Schedule 6, para 5.2) requires that valuation reports include a sensitivity analysis showing the impact of a 100-bps change in the risk-free rate and a 1% change in the MRP on the valuation. For a company with a WACC of 8.5%, a 100-bps increase in the risk-free rate—holding the MRP constant—raises the cost of equity by 100 bps (since the risk-free rate appears linearly in CAPM), increasing WACC by approximately 60 bps (assuming a 60% equity weight). A 1% increase in the MRP raises the cost of equity by the beta multiple (e.g., 1.2% for a beta of 1.2), increasing WACC by approximately 72 bps.

The SFC’s 2025-26 Business Plan specifically flags “valuation assumptions in IPO prospectuses and takeover documents” as a priority area for inspection. The SFC expects that the sensitivity analysis be performed using the same risk-free rate and market portfolio as the base case, with a clear explanation of the ranges. For Hong Kong-listed companies, the standard range for the risk-free rate is typically ±100 bps around the 10-year HKD OIS rate, and the MRP range is ±1% around the chosen estimate.

Actionable Takeaways

1. Adopt the 10-year HKD OIS rate as the risk-free rate for HKD-denominated cash flows, aligning with the HKMA’s SPM CA-MR-1 (2024) requirement for authorised institutions, and ensure consistency between the cost of debt and cost of equity inputs to avoid a systematic 15-20 bps mispricing in WACC.

2. Match the market portfolio to the company’s operational exposure—use the Hang Seng Index for Hong Kong-focused firms, the Hang Seng Tech Index for technology companies, and the MSCI China Index for firms with significant PRC revenue, and document the justification in compliance with the SFC’s Takeovers Code (2023, Schedule 6).

3. Disclose the maturity of the risk-free rate relative to the project or asset life in all valuation reports, as required by the SFC’s 2024 consultation paper on valuation disclosures, and perform sensitivity analysis with a ±100-bps range around the chosen rate.

4. Use the arithmetic mean MRP for short-term projections and the geometric mean for long-term horizons, with explicit reference to an independent source such as the PwC “Risk Premiums for Equity Markets” report (2024 edition), to avoid a 30-50 bps error in WACC for firms with a beta above 1.0.

5. Conduct a cross-currency risk-free rate adjustment for cross-border cash flows—for PRC-renminbi cash flows, use the 10-year Chinese government bond yield (2.65% as of 30 June 2025) rather than the HKD OIS rate, to prevent a 40-bps overstatement of WACC for a 50% equity-financed project.