Session 3: The Risk Free Rate

Introduction to Risk-Free Rates

In this section, the speaker introduces the concept of risk-free rates and explains how they are used in valuation.

Estimating a Risk-Free Rate

• To estimate a risk-free rate, most people look up government bond rates.

• However, it's important to ensure that the entity issuing the security has no default risk.

• In this session, the speaker will lay out how to best estimate a risk-free rate and why those rates may differ in different currencies.

Consistency Principles in Valuation

• When doing valuation, consistency is key.

• If you have cash flows to equity, use cost of equity as your discount rate.

• If you have cash flows to the business, use cost of capital as your discount rate.

• Cash flows can be evaluated either in nominal terms or real terms.

Cost of Equity

• The cost of equity for riskier investments should be higher than for safer investments.

• Measuring risk is difficult; finance textbooks tend to define it in terms of statistical measures like standard deviation and volatility using stock prices.

• When valuing a company, consider how risky it is to marginal investors who set prices for that stock.

Risk and Return Models in Finance

• Traditional finance theory assumes that marginal investors are diversified institutional investors owning tens or hundreds of stocks.

• The list of potential risk and return models includes: Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), Fama-French Three Factor Model, and more.

Investment Models

This section discusses different investment models, including the arbitrage pricing model and multi-factor model.

Types of Investment Models

• The arbitrage pricing model and multi-factor model measure market risk in different ways.

• The arbitrage pricing model leaves market risk factors unnamed while the multi-factor model puts economic names on those factors.

• Proxy models give up measuring risk and use something else as a stand-in. Two widely used proxies are small companies and low price to book stocks.

• Almost every traditional risk and return model uses beta to measure risk with a proxy thrown into the mix.

Risk-Free Rates

This section explains what is meant by a "risk-free rate" and how to calculate it.

Characteristics of Risk-Free Rates

• For something to be considered risk-free, there can be no default or reinvestment risks.

• When looking for something that is default-free, you need to find something matched up to the cash flows you're trying to discuss.

Estimating Risk-Free Rates

• To estimate a US dollar risk-free rate, look up a long-term government bond rate in the currency of interest.

• If your cash flows extend forever, use the longest term rate available (e.g., 30-year bond rate). Otherwise, use the 10-year bond rate.

Finding the Risk-Free Rate

In this section, the speaker discusses how to find a risk-free rate for valuation purposes. They explain that the US Treasury bond rate is often used as a risk-free rate, but caution that it assumes the US Treasury is default-free. The speaker then goes on to discuss how to find a risk-free rate in Euros and nominal reais.

Using TIPS Rate as Risk-Free Rate

• The TIPS (Treasury Inflation-Protected Securities) rate can be used as a risk-free rate if your valuation is being done in real terms.

• If you're doing a nominal US dollar valuation, the TIPS rate should not be used.

Finding Euro Risk-Free Rate

• To find a euro risk-free rate, look for government bonds denominated in euros.

• However, rates are different because some governments have perceived default risks.

• Use the lowest of those 10 EUR government bond rates as close to default free.

Finding Nominal Reais Risk-Free Rate

• Find ten-year government bonds denominated in reaiize.

• Check if it's default free by using Moody's rating or CDS spread.

• Subtract out estimated default spread from government bond rate to come up with nominal reais risk-free rate.

Sovereign Rating and Default Spread

In this section, the speaker explains how to convert a sovereign rating into a default spread.

Converting Sovereign Rating to Default Spread

• A country's sovereign rating can be converted into a default spread.

• For instance, if a country has a sovereign rating of b-double-a, the default spread given that rating is 1.75 percent.

Country Risk Score

In this section, the speaker discusses what to do if your company or country does not have a rating, CDF spread or dollar-denominated bond.

Finding Country Risk Score

• If your company or country does not have a rating, CDF spread or dollar-denominated bond, you can find a country risk score.

• PRS provides numerical country risk scores.

• To find the default spread for such countries, try to find a rated country with the same score and use its default spread as an estimate.

Summing Up

In this section, the speaker summarizes what was covered in the session.

Getting Expected Return or Discount Rate

• The first building block to get to an expected return or discount rate is the risk-free rate.

• It may be easier to get in some currencies than others but it is necessary for every currency evaluation.