How do we choose the Risk Free rate?
Usually, Risk Free rate is the yield on a bond that carries zero risk.
But what bond would qualify for this.
Remember, for a bond to be risk free – it should not have
1) Default risk
2) Reinvestment risk
3) Liquidity Risk
Government bonds are considered risk free, but with a fine print. We have seen some governments default on loans. Argentina has done it in the past, Sri Lanka more recently.
But Government bonds in Local Currency satisfy the first part. In case of a problem, the government can resort to printing money and repaying. The above cases of government defaults were on foreign currency loans, since they can’t print dollars.
Reinvestment risk arises as we can’t be sure of investing the coupons received on a bond at the same yield. That is because market rates may have changed from the time the bond is purchased to the time the coupon is received. Hence, we pick a Zero Coupon bond. As it does not pay any coupon, the issue of reinvestment does not arise.
Finally, we want a bond that is very liquid, and trades frequently, so we don’t get incorrect prices / yields on it. Also, we want a longer term bond, as we are using this to value equities over the longer run. The 10 year Government Bond usually is the most liquid.
Hence, the correct choice for the Risk free rate that satisfies all 3 conditions is the yield on the 10 year Zero Coupon bond issue by the government in local currency.
If such a bond does not exist, a theoretical zero coupon curve given by agencies such as CCIL India can be used.
That is broadly it from us this week. If there are any topics you want us to write on, please share with us.