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Estimating The Risk Free Rate: Aswath Damodaran

This document discusses estimating the risk-free rate when direct risk-free investments are not available. It provides that for an investment to be truly risk-free, the cash flows must be certain and there can be no default or reinvestment risk. When direct risk-free investments do not exist, the document outlines three approaches to estimate an implied risk-free rate: 1) Using sovereign bond spreads relative to benchmark rates, 2) Using credit default swap spreads, and 3) Estimating a spread based on sovereign credit ratings. The document uses Brazil as an example case study in applying these approaches to estimate a risk-free rate in Brazilian real.

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95 views11 pages

Estimating The Risk Free Rate: Aswath Damodaran

This document discusses estimating the risk-free rate when direct risk-free investments are not available. It provides that for an investment to be truly risk-free, the cash flows must be certain and there can be no default or reinvestment risk. When direct risk-free investments do not exist, the document outlines three approaches to estimate an implied risk-free rate: 1) Using sovereign bond spreads relative to benchmark rates, 2) Using credit default swap spreads, and 3) Estimating a spread based on sovereign credit ratings. The document uses Brazil as an example case study in applying these approaches to estimate a risk-free rate in Brazilian real.

Uploaded by

Irfan Khan
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Aswath Damodaran

ESTIMATING THE RISK FREE RATE


Aswath Damodaran http://www.damodaran.com

Ingredients for a risk free investment


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For an investment to be risk free, you have to know your expected return with certainty. Thus, an investment can be risk free only if The entity making the cash flow has no default risk There is not reinvestment risk Consequently, even if you have a default free entity, the risk free rate will vary, depending on the time period of your cash flow. In valuation & corporate finance, we assume that since the cash flows extend over long periods, it is a better approximation to use a long term (ten-year), default free rate as the risk free rate.

Aswath Damodaran

The risk free rate when there is a default free entity (perhaps)
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Risk free rates on 2/20/13 Australian $: 3.55% Canadian $: 2.02% Danish Krona: 1.81% Euro: 1.65% Yen: 0.75% NZ $: 3.92% Swedish Krone: 2.02% Swiss Franc: 0.77% British : 2.18% US $: 2.01%

Financial Times Benchmark Government Bonds Published every day

Aswath Damodaran

If there is no default free entity, you have to estimate a risk free rate
Government Bond Rates & Risk Free Rates

10% 9% 8% 7% Axis Title 6% 5% 4% 3% 2% 1% 0% Default Spread Riskfree rate Government Bond rate 3% 7% Risk free rate 0% 7%

The starting point: The Government Bond Rate in the local currency

On 2/20/13, the ten year Brazilian $R bond was yielding 9.71%

Approach 1: Estimating Default Spreads from $ or Euro denominated bonds

Comparing the Brazilian $ denominated bond rate to the US treasury bond rate gives you a measure of the default spread for Brazils sovereign $ debt. Since Brazils local currency rating = foreign currency rating, you may be able to get away with this spread.

FT screwed up on these. Should have compared to German Euro bond rate, not US.
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Approach 2: Using a CDS spread


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CDS spreads are in basis points. On 2/20/13 Brazils CDS spread was 1.59%.

Aswath Damodaran

Approach 3: Estimate a spread based upon a sovereign rating


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Convert rating to default spread


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Brazils Baa2 rating -> 1.75% default spread

Aswath Damodaran

Estimating a risk free rate in $R on 2/20/13


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Approach 1: Government Bond spread 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% Approach 2: The CDS Spread The CDS spread for Brazil on 2/20/13 was 1.59%. Riskfree rate in $R = 9.71% - 1.59% = 8.12% Approach 3: The Rating based spread Brazil has a Baa local currency rating from Moody s. The default spread for that rating is 1.75% Riskfree rate in $R = 9.18% - 1.75% = 7.43%
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Aswath Damodaran

Desperation time?
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If your government has no dollar denominated bonds, no CDS spread but has a sovereign rating (Example: India): Use approach 3 If your government has no sovereign rating, no CDS spread and no dollar denominated bonds, you can try to get a country risk score from a service like PRS and find a rated country with a similar score. Odds are, though, you will be better off doing your analysis in a different currency.
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Aswath Damodaran

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