Session 5: Estimating Hurdle Rates - The Risk free Rate

Summary

In this corporate finance session, the speaker delves into the concept of the risk-free rate, a fundamental element in finance. A risk-free rate is derived from investments with guaranteed returns and zero default and reinvestment risk. The session discusses the complexities involved in determining the risk-free rate, such as variations across countries and currencies. The speaker also explores different approaches to calculating risk-free rates for currencies with default risks, emphasizing the importance of adjusting for inflation and currency variations. This understanding is key for evaluating hurdle rates and expected returns in investment analysis.

Takeaways

• 😀 The risk-free rate is a fundamental concept in finance and refers to the return on an investment with absolute certainty and no default risk.
• 😀 To define the risk-free rate, two conditions must be met: zero default risk and no reinvestment risk.
• 😀 In practice, risk-free rates can be challenging to measure, especially when there are different cash flows over time (e.g., 1-year, 2-year, 10-year).
• 😀 The risk-free rate can vary depending on the maturity of the cash flow. For example, a 1-year cash flow should use a 1-year zero-coupon bond rate, while a 10-year cash flow would require a 10-year zero-coupon bond rate.
• 😀 A practical solution for determining the risk-free rate is to use a bond with a duration matching the weighted average duration of the cash flows, especially for corporate finance evaluations.
• 😀 In many cases, a 10-year U.S. Treasury bond is commonly used as a proxy for the risk-free rate in U.S. dollar-denominated analyses.
• 😀 When considering different currencies, the risk-free rate should be in the same currency as the cash flows to ensure consistency. For instance, using a 10-year German government bond rate for euro-denominated analyses.
• 😀 If there is no default-free entity in a currency, an alternative is to estimate the risk-free rate by subtracting the default spread from the government bond rate of that currency.
• 😀 For currencies with sovereign default risk, the risk-free rate can be derived by adjusting the government bond rate to account for the default risk spread, which can be obtained from sovereign credit ratings or the CDS market.
• 😀 Inflation rates and their impact on risk-free rates must be considered, as high inflation currencies typically have higher risk-free rates, and low inflation currencies tend to have lower rates.
• 😀 The currency of the analysis matters when assessing risk-free rates—cash flows and the discount rate should be aligned in terms of currency to avoid mismatches in the analysis.

Q & A

What is a risk-free rate in finance?

A risk-free rate is the return on an investment that is guaranteed with zero default risk and no reinvestment risk. It is typically represented by the return on government bonds of a default-free country, like U.S. Treasury bonds.

What are the two key conditions for an investment to be considered risk-free?

The two key conditions for an investment to be considered risk-free are: 1) The entity issuing the bond must have zero default risk, and 2) There must be no reinvestment risk, meaning future reinvestments should not be subject to unknown rates.

Why is it problematic to use a short-term bond as a risk-free investment for long-term cash flows?

Short-term bonds may not be suitable for long-term investments because they involve reinvestment risk. For example, if you use a 6-month bond for a 10-year project, you would need to reinvest the bond every 6 months, and you cannot predict the reinvestment rates in advance, which introduces uncertainty.

What is 'duration matching' and how does it help in choosing a risk-free rate?

Duration matching is a method used to manage interest rate risk by aligning the average duration of assets with the average duration of liabilities. In the context of choosing a risk-free rate, it involves using a bond with a duration that approximates the weighted average duration of your cash flows, typically using a 10-year zero-coupon bond for simplicity.

How do currency choices affect the risk-free rate in investment analysis?

The currency used in an investment analysis determines the risk-free rate. If you are analyzing an investment in U.S. dollars, for example, you would use the U.S. Treasury bond rate as the risk-free rate. Similarly, for euros, you would use the German government bond rate, assuming it is default-free.

What challenges arise when trying to determine the risk-free rate in currencies where there is no default-free entity?

In currencies where there is no default-free entity, such as in many emerging markets, analysts must estimate the default risk and adjust the government bond rate by subtracting the default spread to arrive at a risk-free rate. This requires assessing the sovereign rating or finding alternative market-based measures like CDS spreads.

What approach should an analyst use if there are no suitable default-free bonds available in a currency?

If there are no suitable default-free bonds in a currency, an analyst can either estimate the default spread based on sovereign ratings, use a synthetic risk-free rate by adding expected inflation to a real interest rate, or switch to another currency where a risk-free rate is available.

How does inflation affect the risk-free rate across different currencies?

Inflation has a direct impact on the risk-free rate. High-inflation currencies tend to have higher nominal risk-free rates, while low-inflation currencies tend to have lower nominal rates. However, switching to a lower inflation currency does not always offer a benefit, as it can lead to currency exchange risks when adjusting cash flows.

Why might an analyst choose to conduct investment analysis in a different currency, such as U.S. dollars, even if the local currency is available?

An analyst might choose to use a different currency, such as U.S. dollars, to simplify the process of estimating the risk-free rate, especially in cases where the local currency's government bonds are not suitable or do not reflect a default-free rate. This approach also avoids the complexities of estimating default spreads in the local currency.

What are some methods to estimate the default spread for a sovereign bond?

The default spread can be estimated using several methods: 1) By looking at the difference in yields between local government bonds denominated in a stable currency (e.g., U.S. dollars or euros) and the sovereign bond, 2) By examining the CDS (Credit Default Swap) spreads, which reflect market perceptions of default risk, or 3) By using a lookup table based on the sovereign rating, which provides typical default spreads for different rating categories.