Risk Free Rates – Back to Basics

For this week we decided to present you with the risk-free rates of the regional currencies, which are one of the crucial components of calculating the cost of capital and is therefore an important factor in valuing companies.

Put simply, a risk-free rate is a return an investor would earn on a guaranteed investment. The risk-free rate could be considered as a starting point for calculating the cost of capital.

Although there are certain disagreements when it comes to determining what can be considered as a risk-free rate, it is still one of the crucial components of calculating the cost of capital and is therefore an important factor in valuing companies.

The risk-free rate is negatively correlated with the value of a company, meaning that other things held constant, a higher risk-free rate would lead to a higher discount rate and therefore a lower valuation (and the other way around). 

To consider an investment risk free, two conditions have to be met:

  • The entity issuing the security should have no default risk
  • There should be no reinvestment risk

The first condition in a way implies that the security should be issued by a government, because even the largest private companies bear default risk, at least to a certain extent. However, it is also important to note that not all governments are risk free. For example, when looking at the below selected euro denominated 10-year government bonds one can notice a difference between the rates. The only reason why these rates differ from each other is because the markets deem that some of these governments bear default risk. Therefore, we can conclude that of the selected countries, the markets perceive Romania to bear the highest default risk, while since Germany is a triple A rated country, it can be perceived as risk free.

Return on a 10 Year Government Bond (EUR)

Source: Bloomberg, InterCapital Research

So if we were to value a Slovenian company, one way to estimate a risk free rate for would be by not using the Slovenian 10 year bond, but the German one instead, as it is perceived to be default free. In a sense, analysts are trying to find a riskless investment based on the currency which is being invested in, while the risk of operating in that country should be reflected in the country risk premium, which is a part of the equity risk premium. To read our blog on equity risk premiums click here.

As above stated, the difference between the return on the euro denominated bonds is the country default spread, which should be equal across currencies. What this means is that if we were to, for example, estimate the risk-free rate for a Croatian company, one way to do it would be by subtracting this default spread from the Kuna (HRK) denominated 10-year government bond. By doing this we would get to a risk-free rate of -0.47%. In the graph below you can observe the risk-free rates for other selected countries. As visible on the graph, the risk-free rates vary across currencies, which can be attributed to inflation. Logically, high inflation currencies have high risk-free rate and the other way around.

Risk Free Rates of Selected Countries* (%)

Source: InterCapital Reseach

*based on the 10 year government bonds denominated in the currency of the respective country

It is also worth asking why are many analysts usually using 10-year government bonds to get to the risk-free rate. To answer that question, one must understand reinvestment risk. Let’s assume that we considered a German Schätze as a way to get the risk-free rate, as it is considered to be default free. After 2 years, one would have to invest again at a rate currently unknown, which represents reinvestment risk. Since doing valuation requires estimating cashflows over a long-term period, we would need to consider a long-term risk-free rate, for which the 10-year bond (preferably a zero coupon bond) is considered suitable.

Dino Durrigl
Published
Category : Blog

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