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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