Risk free rate of return
“If you know the rate of return on any investment with
almost 100 percent certainty, this rate will be risk free rate of return. But
finding such a rate is not a cake walk as it requires deep dive into confusing
world of interest rates.”
One school of analysts believes that
if a security has no risk of default, it would be risk free rate of return. So
now focus turns to “do we really have securities with zero risk.”?
No we don’t have but we assume that these
rates would be risk free rate of return with almost but not exactly 100 percent
certainty e.g. government securities, LIBOR etc. Further presence of sovereign
risk complicates the process to find such a security and we cannot forget how LIBOR
spread converged during financial crisis of 2008. So it is really hard to find
such a rate.
They also assume that there is no
reinvestment risk. If coupons on the bonds are invested at rates other than
predicted, the security possesses reinvestment risk. But if a bond with long
term e.g. 10 years or more time horizon is a zero coupon bond (with no
reinvestment risk), then the return on that bond will be risk free rate of
return.
Next point worth noticing is to
evaluate whether required risk free rate of return is real or nominal.
T-bills and government bonds offer
returns that are risk free in nominal terms, we have to adjust them for
inflation because in countries like India with fluctuating inflation we may
observe rapid and frequent changes in inflation and consequently in risk free
rate of return.
In practice, where demand for risk free rate is
quite deep and broader like in valuations based on CAPM model, we may require
risk free rate of return for a scenario
where we don’t have default free entities, in these cases it further becomes
too difficult to estimate risk free rate of return.
We can argue that we will be able to
fetch quite reasonable risk free rate of return estimates in these cases as
well. We can observe longest and safest firm in the market and use the rate
they pay on their long term borrowings in the domestic currency.
In a country where default risk of
the government is quite high and it is not possible to use rate using any
specific firm, we would rather use government borrowing rate less default
spread of the bond issued by the government. To find default spread we can use
default spread provided by credit rating agencies. Although these approaches
are proxies to the risk free rate of return, but they are quite reasonable to
be treated as risk free rate of return.
Thanks & Regards
PureValue Research Team
Contact Details
314, Jaina Tower-1,
District Centre Janak Puri,
New Delhi-110059
M: +91-9811342484
T: +91-11-25258034
E:
info@pvalueresearch.com
W: www.pvalueresearch.com
