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Risk Free Rate of Return

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.

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Holistic Approach towards Risk Management

Focus: Are we waiting for a new disaster to swallow all of our generated wealth or we are not sufficiently informed about all the facets of the risk management.

As Peter Drucker says:

“A business has to try to minimize risks. But if its behavior is governed by the attempt to escape risk, it will end up by taking the greatest and least rational risk of all: the risk of doing nothing”.

From last several decades corporate trend is to focus on corporate governance whereas, risk governance is perceived and inclined towards the financial risk management of the organizations. Events in the recent past in case of LTCM, Barings, Metallgeselschaft, Satyam, P&G etc. taught us strict lessons of improper risk management practices. Companies have now started realizing that it is only partial and biased view towards the risk management.

There are two angles to look at risk management. First, risk management has other unexplored dimensions like operational, strategic and hazard risks. Second angle points out that, risk is not only a negative outcome of an unwanted or unexpected event, but also, an indication of potential benefit at the cost of risk. How much proportion anyone wants to distribute between risk and opportunity is the need and taste of decision makers and art of the risk manager.

Earlier, much of the focus of risk management has been on financial risk management only by managing fluctuations in financial parameters like interest rates, exchange rates, inflation etc. Risk managers worldwide are now shifting gears to practice risk management in synchronized and holistic way which is termed as Enterprise Risk Management. In many organizations the purchase, treasury, HR, legal and finance departments handles risks independently at the department level, which is not an appropriate way. An organization-wide view of risk management may tremendously raise the efficiency to peak level and generate synergies among the departments.

Task of the risk manager is to classify and interpret relevant risk measures as per the need of the organization since it is not possible to list the full gamut of potential risks. Moreover, one template of risk classification cannot generalize risk management for all organizations.
If we consider BASEL II framework for non-financial firms, it distributes risk into three categories –

1.  Operational risk (business risks, IT, business operations)
2.  Financial risk ( Interest rate, exchange rate, inflation, counterparty, insolvency)
3.  Market based risk.

Other risks which may be considered but not specified in BASEL II are Strategic risks (reputational, political, demographic) and Hazard risks (diseases, fire, theft, crime). So we can say that there is no exhaustive list of all the potential risks for organizations and it is only tailor made structure which is efficient.

Conclusion: Organizations sitting on the assumptions of risk management to be of only financial nature and treating them in piecemeal fashion are prone to risks of crisis in the long run. Holistic approach of risk is the need of latest and future generation of firms. Sooner or later they would be embracing firm-wide perspective of the risk management. Risk management will take new leaps and bounds in the coming future by treating risk management as one of the essential arm of any successful organization.

Thanks & Regards
PureValue Research Team
http://www.pvalueresearch.com/