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Session 5: Estimating Hurdle Rates - The Risk free Rate - YouTube
Channel: unknown
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- In session five of this 36
session Corporate Finance Class
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I'd like to talk about a central input
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into almost everything we do in finance.
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Which is what a risk free rate is.
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A risk free rate is what you can earn
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on a guaranteed investment.
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It should be simple to compute.
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But as we'll see in this
session, you can sometimes
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run into serious measurement issues
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in coming up with the risk free rate.
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In this session five, I'd like
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to talk about the risk free rate.
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To get a hurdle rate you
need a starting point.
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And that starting point is what
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you can make on a guaranteed investment.
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This is a number that we used to think
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very little about 20 years
ago, maybe even 10 years ago.
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It's a number that's become
increasingly controversial
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in the markets we're in right now.
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So let me set up where
we are in this process.
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We started the discussion of
hurdle rates in session four.
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In this session we're going
to look at the risk free rate.
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In other words, we're moving towards using
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the CAPM or some risk and return model
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to come up with an expected return.
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So let me set up what the expected return
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in the CAPM should be.
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The expected return should
be a risk free rate.
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That's a base.
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Plus a beta, which
measures the relative risk
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of your investment times
an equity risk premium.
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Three numbers to get an expected return.
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And in practice I think we
tend to mangle all three.
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I see people, for instance, using
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the current risk free rate.
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In particular, they try to think about
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the six month table rate
or a government bond rate
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as a risk free rate.
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But in particular we need to start with
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that risk free rate and what it is.
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They often will use a regression beta.
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We'll come back and talk about
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the right way of measuring relative risk.
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And they will often look at the past
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to get a historical risk premium.
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This session is going to be focused
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just on the risk free rate.
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So let's start with what
should go into risk free rate.
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Let me go back to my earlier definition
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of a risk free investment.
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A risk free investment is one.
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Where you know exactly
what you're going to make
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with absolute and complete certainty.
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In other words, if you
think you're going to make
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half a percent, that's
what you're going to make.
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So for a risk free rate to exist
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here are the two conditions
that have to be met.
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The first is the entity issuing
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the security can have zero default risk.
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Absolutely none.
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Even a smidgen of default risk
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will not make it risk free.
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Second.
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There can be no reinvestment risk.
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And let me explain what
I mean by this as well.
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If you have a five year cash flow
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a six month table is not risk free.
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Even if you think the U.S.
Treasury is default free.
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And here is why.
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At the end of six months
you got to reinvest
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and reinvest again.
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And reinvest again at rates
you do not know right now.
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So for something to be risk free
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it's got to be issued by
a default free entity.
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And it's got to match up to
when the cash flow comes in.
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Which actually puts us
in a bit of a problem.
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Cause when you do investment
analysis evaluation
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you often have cash flows at
different points and time.
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One year, two years, three years.
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So let's assume you're doing a
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U.S. dollar investment analysis.
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And you're going to see in a minute
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why currency's going to matter.
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You have cash flows in
your one, two, three.
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All the way through your ten.
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If you're a purist and you buy into
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what we've just said in this page
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your risk free rate should actually
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be different for each cash flow.
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For the one year cash flow, I should use
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the one year zero coupon Treasury bond
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because a coupon throws
off my interest rate.
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On the two year cash flow,
I need a two year zero.
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On the three year cash flow I need
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a three year zero all the way through.
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Which means each cash flow will
have its own risk free rate.
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What a pain.
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So I'll offer you a solution that
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might make your life a little easier.
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It comes from what's
called "duration matching".
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It's the way the old banks used to be run.
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And here's how they
manage interest rate risk.
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Rather than take each individual asset
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and match it up to a liability
of equivalent duration
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banks used to take the average
duration of their assets
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and set it equal to the average duration
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of their liabilities.
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What they were trying to do then
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was to reduce interest rate
risk, if not eliminate it.
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We're going to do a variant of that.
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Remember that 10 year
analysis I talked about?
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We have cash flows in
years one, two, three
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all the way through your ten?
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Think of the weighted average duration
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of those cash flows on average.
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In which year did those
cash flows come in?
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If the cash flow is a backhanded
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the bigger cash flows are
towards the end of the life.
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That might be seven.
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Seven and a half years.
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If you can use a risk free rate
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with roughly the same duration,
you're going to be okay.
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It's not going to be perfect,
but you're going to be okay.
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In fact, I'll make life
even simpler for you.
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In much of corporate financing evaluation
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you can assume that a
10 year maturity zero.
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A default free bond, will effectively
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be a pretty good risk free rate.
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So find me a default free ten year bond
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and I've got a risk free rate
for you in that currency.
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So let's start easy.
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In November of 2013, I needed
a U.S. dollar risk free rate.
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I assumed, and this was
not an easy assumption
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as it might have been five
years or 10 years ago.
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I assumed the U.S. Treasury
was still default free.
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And I used a U.S. 10 year T
bond as my risk free rate.
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In November of 2013 that
rate was 2.75 percent.
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That is going to be my risk
free rate in U.S. dollars
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no matter where I do my analysis.
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In other words, if I do an
investment analysis in Indonesia
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but decide to do my cash
flows in U.S. dollars
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my risk free rate is going
to be in U.S. dollars.
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A risk free rate is
driven by what currency
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you choose to do the analysis in.
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Not the company doing it or the country
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in which the analysis is done.
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So that was easy.
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The risk free rate in U.S. dollars
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if you assume the U.S.
Treasury is still default free
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is 2.75 percent.
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Now you're saying, "What if I assume
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there's defaulters in U.S. Treasury?"
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We'll come back to that.
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There's a way to fix that.
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But I'm going to assume the 2.75 percent
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as my risk free rate in dollars.
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Now let's climb the difficulty ladder.
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Let's assume I wanted
risk free rate in euros.
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And I need one to do my Deutsche
bank hurdled rate, right?
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So to get a risk free rate in euros
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I looked up 10 year government bond rates.
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In euros.
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And I ran into a bit of a problem.
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There were at least 10 governments
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that had 10 year bonds
denominated in euros
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and the rates were all different.
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They range from 1.75 percent for Germany
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to much higher rates for
Spain, Portugal and Greece.
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Which are riskier parts of the EU.
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Now which of these rates should
I use as my risk free rate?
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The answer, I'm afraid,
is surprisingly simple.
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If you think about it, these are
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all 10 year euro bond rates.
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Right?
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They're not Drachmas and French Francs
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and Deutsche Marks like there
were 15 to 20 years ago.
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Because they're all in euros
there's only one reason
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why the rates are different.
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Which is the market sees
default risk in some countries.
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And more default risks in
some countries than others.
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It sees more default
risk in Greece and Spain
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and Portugal than it does in Germany.
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So that's the answer.
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If you want a risk free rate in euros
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maybe the risk free
rate you should be using
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should be the 10 year German bond rate.
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The 1.75 percent.
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Cause it's the closest
to being default free.
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If you're a stickler
and argue that there's
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a defaulters even in that
rate, you might be right.
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You could consider using the 10 year bonds
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issued by the European Central Bank.
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The rate on that was what?
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1.73 percent of the time
that I did this analysis?
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That could be a risk free rate in euros.
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In fact, if you're looking at currency
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where the government issuing
the bond is AAA rated
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you can get a risk free rate by using
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the 10 year government
bond rate in that currency.
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So you want a Swiss Franc risk free rate?
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Look up the rate on a 10
year Swiss Franc bond.
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In fact in this graft,
I have risk free rates
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in different currencies
where the government
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at the time that I did this analysis
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was still viewed as default free.
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That a AAA local currency rating
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and have risk free rates that vary across
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these develop market currencies.
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Now that's your easy task.
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What if I came to you and
asked you for a risk free rate
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in a currency where there
is no default free entity?
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In fact, with my company examples
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I have at least three currencies
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where there is default risk.
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One is the Indian rupee.
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Because Start of Moody's
is an Indian company
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and I could get an
Indian Rupee hurdle rate
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and Indian rupee risk free rate.
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The second is Vale, which
is a Brazilian company.
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And if I choose to do the analysis
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in nominal reais, I need a
nominal reais risk free rate.
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And the third is Baidu,
which is a Chinese company
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and I need a risk free rate in Euwan.
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I'm going to set up the process
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for estimated risk free rate in
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these three currencies or any currency
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where the issuing entity has default risk.
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There are three choices you can make.
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The first is you can stay
with the local currency.
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Get a government bond
in the local currency.
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And then net out from
that government bond rate
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the portion that you think
is due to default risk.
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Sounds fancy right?
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Let me take an example.
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In November of 2013, the Indian
rupee government bond rate
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was 8.82 percent.
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That was an Indian
government bond denominated
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in rupees 10 year maturity 8.82 percent.
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However, the Indian government
was not rated default free.
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How do I know?
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I visited the Moody's website and
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I checked under sovereign ratings.
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And the rating for India was not bad.
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It was BAA3.
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But the default spread for
that rating was 2.25 percent.
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There we'll talk about how to
estimate that default spread
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but if you can estimate the default spread
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and you agree with that
number, here's what
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the risk free rate in
India Rupees will become.
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8.82 percent is the government bond rate.
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Some of that is for default risk
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and based on my estimate it should
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be 2.25 percent for default risk.
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You net that out.
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My risk free rate in Indian
Rupees is 6.57 percent.
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8.82 minus 2.25 percent.
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So if you want a risk free
rate in any local currency
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that's all you can do.
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Take the government bond rate.
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Net out the default
spread for that government
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in the local currency.
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You get a risk free rate in that currency.
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So that's your first choice.
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Is stick with the local currency.
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Try to back out from the government bond.
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A risk free rate.
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Now there are other ways
in which you can try
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to tweak out a risk free
rate in a local currency.
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Here are a couple of choices.
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You could take the expected
inflation in the local currency
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and add an expected drill interest rate
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to try to come up with what I call
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a synthetic risk free
rate in local currency.
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You're building one assumption
on top of the other.
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But sometimes you have no choice.
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There are some cases
where you might decide
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getting a local currency risk free rate
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is just way too much work.
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You have an old title.
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You can everything in
a different currency.
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In fact, until very
recently in Latin America
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that's what most analysts
and companies did.
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Rather than try to do
an investment analyses
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in nominal reais or nominal pesos
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they would do them in U.S. dollars.
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You're not avoiding the problem.
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You're just shifting it somewhere else.
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Because now your cost of
capital and hurdle rate
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will be estimated in U.S. dollars.
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But all your cash flows well have
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to get converted into
U.S. dollars as well.
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Which means.
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You replace the estimation prompt
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from the discount rate to getting
an expected exchange rate.
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But if you feel that's an
easier prompt to deal with
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that's a second choice is to
switch to a different currency
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and do your entire analysis
in a different currency.
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There's a third choice.
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You can try avoid currencies all together.
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In other words, rather than do things
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in nominal dollars and nominal pesos
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you can do everything in real terms.
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What I mean by that, is you take inflation
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out of your cash flows.
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In which case, your discount rate
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has to be built off of
real risk free rate.
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One choice you have for
the real risk free rate
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is the TIPS rate.
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That's a U.S. Treasury
Inflation Index Bond.
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At the time of this assessment
for instance, it was
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about one percent.
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That will be a real risk free rate.
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But the key is to make your choice early
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about what currency or
real analyses you're doing
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and get a risk free rate in that currency.
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So let's see what the different ways
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of getting the default spreader.
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Because especially if you
decide to go that first route
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of netting out a sovereign default spread
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from the government bond rate,
you need to get that number.
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There are three ways you
can get a default spread.
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Some cases you might get lucky
and be able to use all three.
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Some cases you might only
be able to use only one.
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And some cases none of them will work.
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One is to look at market base measures.
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And there are two market base measures.
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One is if you have a government bond
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and this is from the local government
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that's being issued in U.S. dollars.
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The Brazilian government,
for instance, has
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10 year bonds denominated in U.S. dollars.
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You subtract out the
T bond rate from that.
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You'll get a measure of the
default spread from Brazil
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because they're both dollar based bonds.
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And the difference in rates has to be
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because the market assesses
default risk in Brazil.
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That's one market base number.
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The other is to go to the
market called the CDS market.
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The Credit Default Swap market.
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There you will see sovereign CDS spreads.
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The sovereign CDS spread for Brazil
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at the time of this
assessment was 2.53 percent.
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That's a measure of how much default risk
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the CDS market sees in Brazil.
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So those are both market based numbers.
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One is the CDS market.
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The other is a government bond denominated
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in dollars or euros.
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But what if you can't find either?
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In November of 2013,
for instance, India did
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not have a CDS spread.
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India did not issue
dollar denominated bonds.
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But India did have a sovereigned rating.
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The third approach, what you do is
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you use the sovereign
rating for the country.
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And you look up a typical default spread
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based in the sovereign rating.
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You say how do I know what
that typical default spread is?
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I create a lookup table
at the start of every year
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where I take all sovereign countries.
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I take their ratings and I estimate
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the average spreads
for each ratings class.
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So if you tell me what your rating is
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I can assess what a typical default spread
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is given that rating.
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Each of these three ways ultimately
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will give you a spread.
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If you can use all three, you have
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to make a judgment as to which one
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you want to hang your hat on.
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If you can get only one,
go ahead and use it.
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If you can get none, maybe it's time
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to switch to a different currency.
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So in closing, let me show you
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what the risk free rates look
like in different currencies
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in January 2014.
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There reigns a spectrum.
[842]
From less than one percent for
the Japanese Yens was franc.
[845]
To more than 10 percent
for the Brazilian Reais.
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I think that's strange.
[850]
Why didn't I just pick the
lowest risk free rate currency
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and do everything in that currency?
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It'll give me a lower hurdled rate.
[855]
You're right.
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But there's a reason
why risk free rates vary
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across currencies and there's
and there's only one reason.
[860]
Which is differences in inflation.
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High inflation currencies
have high risk free rates.
[864]
Low inflation currencies
have low risk free rates.
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If you pick a low inflation currency
[870]
to do your discard rate
then your cash flows
[872]
have to be in that same
low inflation currency.
[875]
What one hand give you the
other hand will take away.
[878]
So there should really
be no benefit of cost
[883]
from going from a low inflation currency
[885]
to a high inflation currency
on the same project.
[888]
That's tough to believe, I know.
[889]
But we will come back and in the context
[891]
of investment analysis hopefully show
[894]
that if you do a good analysis
[896]
it should be currency in variant.
[898]
Currencies matter because of
their expected inflation rates
[901]
and that's good to keep in mind.
[903]
Thank you very much for listening.
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