Cost of Capital

RISK FREE RATE: THE

BASIC BUILDING BLOCK
THE PROBLEM

I • Understand the concept of Risk free

II • Develop a framework of rate selection

• Analyze factors creating sovereign

III default risk
• Calculate risk free rate in case of default
IV risk
WHAT IS RISK FREE ASSET?

• Investors who buy assets have returns that they expect to make over the time
horizon that they will hold the asset.
• The actual returns that they make over this holding period may by very
different from the expected returns, and this is where the risk comes in.
• Risk in finance is viewed in terms of the variance in actual returns around
the expected return. For an investment to be risk free in this environment,
then, the actual returns should always be equal to the expected return.
WHAT IS RISK FREE ASSET?

• There is a second way in which we can think of a riskfree investment and it is

in the context of how the investment behaves, relative to other investments.
• A riskfree investment should have returns that are uncorrelated with risky
investments in a market.
• In summary, an investment that delivers the same return, no matter what
the scenario, and is uncorrelated with risky investments can be considered
as a risk free asset.
WHAT IS RISK FREE ASSET?
• For an investment to have an actual return equal to its expected return there
can be no default risk. Essentially, this rules out any security issued by a
private firm, since even the largest and safest firms have some measure of
default risk. The only securities that have a chance of being risk free are
government securities, not because governments are better run than
corporations, but because they control the printing of currency.
• Second is, there can be no reinvestment risk. A six-month treasury bill
rate, while default free, will not be risk-free, because there is the
reinvestment risk of not knowing what the treasury bill rate will be in six
months.
WHY DO WE NEED RISK FREE INVESTMENTS?
• Asset allocation and Portfolio Management:
• Rather than have investor-specific risky
portfolios, all investors choose to hold the
riskless asset and the market portfolio
• Having access to a riskless investment
therefore allows investors to have their
cake and eat it too.
• They can diversify to the fullest extent
possible across risky assets and then
use the riskless asset to adjust the
overall risk in their portfolios, investing
in the riskless asset to reduce portfolio risk
or borrowing at the riskless rate to
augment portfolio risk.
WHY DO WE NEED RISK FREE INVESTMENTS?
• Pricing of Derivative Assets:
• The presence of a risk-free rate/asset is central to deriving most of
these models, because they are based upon arbitrage, i.e., creating
investment positions that have no risk, require no capital but still
generate a sure or riskless profit.
• Call Option/Long Futures: Borrowing at risk free + Buying the
underlying.
• Put Option/Short Futures: Selling the underlying +lending at risk
free rate
WHY DO WE NEED RISK FREE INVESTMENTS?
• Investment Policy
• Firms should invest in an asset/project only if they believe that they can
generate returns on this asset that exceed a “hurdle rate” that reflects its
risk, having a risk-free asset (and rate) puts a baseline on the hurdle
rate.
• If the cash flows on an investment are guaranteed (and known) at the
time of the investment, the investment has to generate returns that
exceed the risk free rate.
• For riskier investments, the hurdle rate will be comprised of two
components – a base of a risk free rate and a risk premium, reflecting the
perceived risk in the investment.
WHY DO WE NEED RISK FREE INVESTMENTS?
• Financing Policy
• It is common practice in many parts of the world to compute debt ratios and
to measure financial leverage using net debt, which is the difference
between debt owed and cash and marketable securities considered riskless:
• Net Debt = Gross debt – Cash and marketable securities
• To the extent that firms have at least of some of their investments in riskless
assets, it also affects measures of default risk and cost of debt. Ratings
agencies, for instance, weigh in the presence of cash and other riskless
assets on the balance sheet, when assigning bond ratings, and the cost of
debt for a company will be lower, if a larger portion of its assets is invested in
riskless assets.
WHY DO WE NEED RISK FREE INVESTMENTS?
• Dividend Policy
• A firm that pays too little in dividends, relative to cash available for payouts,
can always invest the cash in the risk free asset and thus leave investors
unaffected in terms of overall returns, by substituting price appreciation for
dividends.

• Market Timing and Risk buffer for Mutual Funds

• Mutual funds use risk free T-bills to adjust their overall risk exposure.
• Bearish equity mutual fund mangers sell stocks and buy treasury bills and
bullish managers do the reverse.
IMPORTANCE OF RISK FREE RATE IN VALUATION

#1 #2 #3

Building block in Consequence on • Affects the value of

estimating cost of other valuation growth assets and
equity and debt. inputs assets in place
Risk free rate is added Changes equity risk • High risk free can
to ERP and default premium and debt increase discount rate;
spread default spread decrease value of
Ke = Risk free rate + growth assets in
Risk premium(ERP) proportion to assets in
Kd = Risk free rate + place and reduce firm
Default Spread value.
ESTIMATING A RISK FREE RATE
• An investment can be risk-free only if it is issued by an entity with no
default risk, and the specific instrument used to derive the risk-free rate
will vary depending upon the period over which you want the return to be
guaranteed.
• What is right risk free instrument then?
• T-bill or T-bond?
• Coupon or zero coupon?
• 10 year or 30 year?
• 10 year zero coupon bond is the ideal instrument for risk free rate as the difference
between 10 and 30 year bond rates is small and it is easier to estimate risk premium
against a 10 year bond rather than a 30 year bond
BE CURRENCY CONSISTENT IN RISK FREE RATE
• It is not where a project or firm is domiciled that determines the choice of
a risk free rate, but the currency in which the cash flows on the project or
firm are estimated.
• The risk free rate used to come up with expected returns should be measured
consistently with the currency in which cash flows are measured. Thus, if cash
flows are estimated in nominal US dollar terms, the risk free rate will be the
US Treasury bond rate. This will remain the case, whether the company being
analyzed is a Brazilian, Indian or Russian company.
• Learning : The risk-free rate is not the vehicle for conveying concerns about
country risk.
ESTIMATION OF RISK FREE RATE

• The starting point: Pick the Government Bond Rate in the local currency
• 10 year government bond yields across various countries
• https://tradingeconomics.com/bonds
ESTIMATION OF RISK FREE RATE
• Issue 1: The government does not issue bonds or does not issue
bonds in local currency.
• Possible solution:
• Value the company in mature market currency.(Yen, Swiss
franc, C$, A$, NZ$, GBP, Swedish Krone Norwegian Krone)
• Value in local currency by converting a foreign currency
discount rate, using expected inflation rates
 Solution 1: Value the company in mature market currency
Say a Brazilian Company: Risk free in US is 4% and cost of capital is 9%.
Current BR/$ exchange rate is 2. Inflation in US$ is 2% and BR real is 6%.

Step 1: Compute expected BR/US$ rates for next 3 years.

Step 2:

Cash Flow in Brazilian Real Exchange Rate (BR/$) Cash Flow in US$ Present Value@9%
1 100 2.0784 48.1139338 44.14122367
2 110 2.1599 50.92828372 42.8653175
3 121 2.2446 53.90715495 41.62621451
TV 606.5534114
Value 735.1861671

Step 3: Value in Brazilian Real = 1470.35 (735.18*2)

Which Mature market rate will you use in case you value the company in Euro?
Solution 2: Value in local currency by converting the overall cost of capital
using expected inflation rates
 Solution 2: Value in local currency by converting risk free rate, using
expected inflation rates

You are valuing an Indian company in rupees. The expected inflation rate in the US
is 1.5% but the inflation rate in India is expected to be 6%. If the U.S. treasury bond
rate is 5%, estimate the riskless rate in Indian rupees.

You are valuing a company is Pakistani Rupees and are unable to find a government
bond rate in the currency. If your expectation for inflation in Pakistan is 8% and the
rate on an inflation indexed US treasury bond is 1%, estimate a risk free rate in
Pakistani rupees. Explain why this rate can be used even if your judgement about
expected inflation in Pakistan is shaky.
ESTIMATION OF RISK FREE RATE
• Issue 2: The government is not default free
• Possible solution:
• Adjust the 10 year government bond rate with a default spread:
• Risk free rate = 10 year government bond rate – Default spread
ESTIMATION OF RISK FREE RATE

• How to estimate the default spread

• Approach 1: Estimating Default Spreads from $ or Euro denominated bonds
The 2020 Brazil bond, denominated in US dollars, has a
spread of 0.74% over the US treasury bond rate.
Riskfree rate in $R = 9.71% - 0.74% = 8.97%
 ESTIMATION OF RISK FREE RATE

Schroeder is a European company with operations in three countries and you have been
provided the following information on its operations:
Country Revenues (in Govt Bond rate in Govt Bond rate
millions of Euros) Euros in local currency

Germany 900 1% 1%
Poland 300 2.5% 4% (Zlotys)
Hungary 800 4% 7.5% (Forint)

a. Assuming that Germany is the only Aaa rated company in this group, what would you
use as a risk free rate for the company (in Euros)?

b. Assuming that Poland’s foreign currency sovereign rating is equal to its local currency
rating, estimate a risk free rate in Zlotys?
 FINDING DOLLAR DENOMINATED BONDS FROM BLOOMBERG

SRCH Criteria
Asset Classes: Corporates, Governments
Sources: All Securities
Security:
AND Security Status Include Bonds : Active
AND Currency Include United States Dollar
Original Maturity Greater than or equal
AND (Years) to 10
AND BICS Classification Include Sovereigns
 APPROACH 2: USE A CDS SPREAD

There are no dollar denominated bonds

The buyer of a CDS on a specific bond makes payments of the “spread” each period to the
seller of the CDS; the payment is specified as a percentage (spread) of the notional or face
value of the bond being insured. In return, the seller agrees to make the buyer whole if the
issuer of the bond (reference entity) fails to pay, restructures or goes bankrupt (credit event),
by doing Physical settlement or Cash settlement

What would you use as your risk free rate if you were valuing a Peruvian
company in Peruvian Sol given the 10 year Peruvian govt bond rate is 6%?
(You can assume that the Peruvian sovereign CDS is trading at 1%.)
CDS Spreads form
Bloomberg
 APPROACH 3: USE MOODY’S RATINGS TO ESTIMATE A
DEFAULT SPREAD

There is no active CDS market and the country does not issue dollar
denominated bonds

https://www.moodys.com/researchandratings/research-type/data-
reports/ratings-list/00300A000/00300A000%7C005005/-/0/0/-/0/-/-/-/-
1/-/-/-/en/global/pdf/-/rra

Moodys.com/ratings/ratings list/sovereign and supranational

APPROACH 3: USE MOODY’S RATINGS TO ESTIMATE A
DEFAULT SPREAD
• Convert rating to default spread:
• damodaranonline/data/equity risk premium
• http://pages.stern.nyu.edu/~adamodar/
Brazil has a Baa local currency rating from Moody’s. The default
spread for that rating is 1.75%
Riskfree rate in $R = 9.71% - 1.75% = 7.96%
RISK FREE RATE: CLOSING THOUGHTS

• A risk free rate should be truly risk free.

• Choose a risk free rate which is consistent with how cash flows are
defined.
• Do not go with expected risk free rates. Use the current rates. If
you have strong views on risk free rates, do not incorporate those
in valuation of individual companies.
EXPLORE

• What will happen to risk free rates in negative

interest rates scenario?