I am risk-free rate. Don’t you want to meet me?

Hi, guys. I hope all of you are doing good. Let me introduce myself first and then I will talk about myself in detail. I am risk-free rate. I am generally the yield earned on US Treasuries. But you should keep the treasury till maturity to earn that interest rate. I agree that I am a boring person. But you guys can’t ignore me as you will find me time and again. Become my friend and your ride will be easy. But if you ignore me, then you might be able to clear the exam but you might not be able to become a good analyst. We must be friends. I know you guys must be thinking why the heck you should befriend me. You don’t want risk-free rate. All of you want to earn a much higher return on your investments. But you must remember the adage – “Man must exist in a state of balance between risk and safety. Pure risk leads to self-destruction. Pure safety leads to stagnation. In between lies survival and progress.”

Have I bored you with my introduction? Whether I have bored you or not, you have to understand me like a lover understands another lover. Without understanding me you won’t be able to do justice with the course. You will find me almost in all the courses whether it is equity, portfolio management, fixed income securities, derivatives, economics or corporate finance. I am like the wheel of time (samay chakra) in Mahabharata and you will keep meeting me again and again. Let me tell you more about myself.

US Treasuries can be of any maturity like they can be T-bills having maturity less than a year, T-notes having a maturity between 1 to 5 years or T-bonds having a maturity greater than 10 years. I am the yield which you will get when you invest in any of the above-mentioned securities. But those securities have to be zero coupon securities otherwise there will be reinvestment risk. Your maturity horizon should be exactly equal to the maturity of the US Treasury selected for investment. You can’t invest for one month in a 6-month T-bill and call me risk-free. Can you guess why? Yes, there would be price risk. As interest rates keep on changing. It can happen that after one month the interest rate might have changed and you would earn higher or lower return than the risk-free rate because of taking price risk.

Now you must be thinking that I belong to the USA only and the currency USD only. But let me tell you that I am a world traveler. You will find me residing in all the countries. You can say that I am the only globalized person in the true sense. Give me a currency and you will find different risk-free rate. Suppose you want to find out the risk-free rate in some country say Japan. What will be the risk-free rate on the Japanese Yen? You might be thinking that it would be the yield on zero-coupon securities issued by Japanese Government. But you are wrong because Japanese Government might not be entirely risk-free. Only the countries with AAA rating are considered as risk-free. The Japanese Yen would have some risk attached to it. To get the risk free rate on the Japanese Yen, you need to subtract the CDS premium from the yield earned by you. Now you might say that there is still some credit risk with CDS as it is not exchange backed and a customized instrument and the counter-party might default. But that credit risk would already be there in the calculation of CDS. So, you need not worry about that. Now suppose the yield on the zero-coupon government bond issued in Japan is 6% and the CDS is traded as 2.5% in the market, then my value will be 4.5%.

I am easy to calculate when CDS are being traded actively in the market. But for some countries like India, there is no CDS market. For calculating risk-free rate in INR, you need to go through the credit rating route. Check the rating of Indian debt and for similarly rated debt check the value of CDS for another country and use that as a proxy and subtract that from the yield to get the risk-free rate. So, suppose CDS of a similarly rated country comes out to be 4.5% and the Indian debt is traded at 8.0%, then the risk-free rate in India is 3.5%.

Now you might be thinking that why I am risk-free for AAA-rated countries like the USA. Isn’t there a possibility that the USA might default as well on their debt? Yes, it can very well  happen and you can sense from the CDS market. If there is some CDS premium for US debt, then you need to subtract that from the yield to get the correct risk-free rate. You can go through this document to check the risk-free rates for various countries.

I hope you have understood me well and give right treatment to me when you meet me again. You will be needing me in all kind of valuations whether you would be valuing equity, debt, or alternative assets. I hope you won’t make costly mistakes in your analysis and I am the most important input in the valuation. I will meet you soon. Till then sayonara.

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ThinkMarkets

A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market OrderEconomic Processes & the Leipzig Colloquium on the Foundations of the Market Order

Fundoo Professor

Thoughts of a teacher & practitioner of value investing and behavioral economics

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