Relationship between franking credits and the market risk premium: a comment

This paper examines two arguments presented in Gray and Hall (2006). First, that the generally used estimate of 0.06 for the market risk premium within the Officer version of the capital asset pricing model (CAPM) and the generally used estimate of 0.50 for the parameter ‘gamma’ within the Officer framework are jointly inconsistent with evidence concerning the market risk premium in the standard version of the CAPM. Second, that the first two of these parameter estimates are also jointly inconsistent with the observed cash dividend yield on the Australian market. To resolve these problems, Gray and Hall recommend setting gamma to zero. The present paper shows that the first argument does not account for the fact that imputation induces a reduction in the market risk premium as defined in the standard version of the CAPM. The present paper also shows that both arguments identify a problem that characterizes only parts of the Officer framework, and these parts are not generally used in Australia. Therefore, rather than suggesting that gamma should be zero, Gray and Hall's analysis identifies parts of the Officer framework that should be avoided.