Introduction
In finance and valuations, the term "risk-free" holds immense weight. It conjures images of secure investments, promising a guaranteed return without a hint of loss. The Capital Finance Institute (CFI) defines the risk-free rate as "the interest rate an investor can expect to earn on an investment that carries zero risk." However, therein lies the rub – true risk-free investments are like unicorns: mythical creatures that might not exist.
In reality, the risk-free rate represents a theoretical ideal, a benchmark against which other investments are measured. While there's no perfect haven, some investments come close. Government bonds issued by highly stable countries, like U.S. Treasuries, are often used as proxies for risk-free assets. These bonds carry a shallow default risk, meaning the chance of the government not repaying the investor is minimal. However, even these seemingly safe investments are not entirely without risk.
Nominal Rate vs Real Rate
The concept we typically encounter is the nominal risk-free rate. This rate focuses solely on the interest earned on the investment, without considering the impact of inflation. The nominal rate can be thought of as the real interest rate (the true return on investment) plus an expected rate of inflation. So, in periods with high anticipated inflation, the nominal risk-free rate will rise. But does that translate to a higher risk-free return for investors? Not quite.
The real rate takes inflation into account, providing a more accurate picture of the investor's actual return. Imagine you invest in a risk-free asset with a nominal rate of 5% during a time of 3% inflation. While the nominal rate suggests a 5% gain, the real rate, adjusted for inflation, is only 2%. This highlights the importance of considering inflation when evaluating risk-free returns.
Understanding the risk-free rate, both nominal and real, is crucial for financial professionals and investors alike. It serves as a foundational concept in various valuation models, including the discounted cash flow (DCF) method. By incorporating the risk-free rate into these models, analysts can arrive at a more accurate assessment of an investment's true worth, considering both the potential return and the inherent risk.
The quest for truly risk-free investment might be a never-ending pursuit, but the concept of the risk-free rate remains a valuable tool in navigating the often-turbulent waters of finance.
Real Risk-free Rate = (1+Nominal Risk-Free Rate)
(1+Inflation Rate)
Impact of Deflation
This leads us to the question, “Can Risk-Free Rates turn negative due to deflation in the economy? A simple answer to this would be a yes. If the economy undergoes or is expected to undergo a significant level of deflation, the risk-free rates turn negative. It is seen that economies with higher inflation rates have higher risk-free rates. However, the negative figures that we see as risk-free rates are the nominal ones. Real risk-free rates cannot turn negative.
Moreover, a scenario as such where the risk-free rates turn negative does not bring about any fundamental change in valuations. What is to be kept in mind is that the project cash flows or other items do show this effect of expected deflation.
Every economy has a different rate of inflation. Adjusting for it, we derive the Real Risk-Free Rate. But why does this happen that different economies have different Risk-Free Rates?
Different risk-free rates in different economies
If inflation isn’t taken into account, two factors constitute a Risk-Free Rate. One of them is the growth rate of the economies. Developing economies with higher growth rates can have governments offering higher returns on sovereign securities. Generally, a higher economic growth rate implies a higher risk-free rate in the economy as profits rise due to increased economic activity along with a demand for borrowing. This increased demand for funds pushes interest rates up. In such a scenario, there is always an expectation of a rise in inflation with the economic growth which further soars interest rates. This has an automatic adjustment effect as lower risk-free rates increase the demand for borrowing and lending which boosts economic activities.
But to prove that the growth rates of economies aren't the only factor affecting risk-free rates, we take an example of two countries: Sri Lanka and Malaysia
The yearly growth rate of the Sri Lankan economy is approximately 7% and that of Malaysia is about 6%, as an average of the last two years, which is about the same as the one of Sri Lanka. But when we look at their risk-free rates, we find a significant difference in them. Taking the 10-year government bond yield as a ‘proxy’, the Sri Lankan bonds currently yield about 13.42% while the Malaysian ones pay off some 3.88%.
Why do these not have the same Risk-Free Rate when the growth rates of their economy are about the same? There is, surely, a difference in their inflation rates but the difference in their government bond yields or risk-free rates is far more. This leads us to the second factor affecting Risk-Free Rates and that can be found by answering the question, "Are Risk-Free Rates truly risk-free?"
A simple Answer to this would be a no. Risk-Free Rates aren’t truly risk-free and some risk is attached to them, even if negligible. We consider the yields of bonds issued by the government risk-free due to the notion that a government of the country cannot default. They can always print more money to pay off their debts, right? Not always. In certain scenarios, the governments should default rather than print more money and push up the inflation rates.
In 2001, the government of Argentina defaulted on more than US$ 132 billions of federal sovereign debt. Out of which, $40 billion were in international bonds, with approximately half of these bonds being held by foreign investors. These defaults take place because the government deems it better than printing more money which would resultantly cause a case of hyperinflation, like it did with Zimbabwe in 2008 with an inflation rate of 79,600,000,000% per month. The hyperinflation was primarily caused by excessive money printing to finance budget deficits, economic mismanagement, etc.
With this, we can conclude that the governments can default and your investment in the government is not risk-free. This risk is further accompanied by foreign exchange risk and hence makes the Risk-Free Rate across countries vary.
(Source: Aswath Damodaran, NYU Stern (1))
Here, we will demonstrate it with an example.
Now, the growth rates of the economies along with some other minor factors are making the risk-free rates of the particular markets get their value.
However, in some cases, for example, in the Pakistani Rupee, the value of the risk-free component is just about 1%. However, the risk-free rate lies at about 7% due to ~6% of default spread. This is happening due to the high default risk of the Pakistani Government whose credit rating lies at B3 (Moody’s) (As of April 2021).
If you confirm it from the table, the default spread for a B3 rating lies at 6.63% which is about the default spread of the Pakistani government buffing up the risk-free rate. But for New Zealand Dollars, or the US Dollars (Aaa), the rating lies the highest in Moody’s standards and hence their default spread remains at 0%. For India. The rating lies at Baa3 which implies a spread of 2.26%. This 2.26% adds up to ~5% to make the Indian risk-free rate for 10 years to be about 7.3%.
(As of 20/4/24) (Source: Investing.com (2))
Another way to go about this for a particular country is to determine the bond yields on the government bonds issued by the sovereign state of that particular country but denoted in the US Dollars. In such a scenario, that rate will be a risk-free rate as the US economy has an Aaa rating. If such a thing is not found in a particular country, for example, in India, there are no government bonds that are USD-denominated. In such a case, what should be done is to determine bonds denominated by some other currencies and then use their default spread of that currency to adjust it to a true risk-free form. However, if that is not found, the credit rating of the economy can be used to determine a true risk-free rate.
Impact of Bond Yield Inversion on Risk-Free Rates in the Economy
Yield inversion, where short-term interest rates exceed long-term rates, significantly impacts risk-free rates like government bonds. This happens because investors anticipate a future economic slowdown, leading them to seek the safety of long-term bonds. This increased demand pushes down long-term yields, causing them to fall below the yields of shorter-term bonds, effectively lowering the risk-free rate. This shift in the yield curve signals a potential recessionary environment where investors prioritize securing their capital over maximizing returns.
(US Treasury data on August 14, 2019) (Source: CNBC (3))
Effect of Rate fluctuations
Now that we see how various countries have different risk-free rates based on a variety of factors, a minimal change that can cause the rate to fluctuate significantly, how badly can these fluctuations impact the fundamentals of various financial calculations?
The risk-free rate plays a crucial role in determining the valuation of shares. A common method for valuing shares, DCF (Discounted Cash flow model)
involves estimating a company's future cash flows and then discounting them back to their present value. The discount rate used in this process is heavily influenced by the risk-free rate. A higher risk-free rate means a higher discount rate.
Why? Because investors demand a greater return to compensate for the additional risk of owning shares compared to a risk-free investment. As a result, when the risk-free rate rises, the present value of the company's future cash flows gets discounted more heavily, leading to a lower share price.
The above example illustrates how with a mere change in the risk-free rate, a drastic change occurs in the value of a share.
Importance of the risk-free rate
The risk-free rate, though seemingly simple, plays a surprisingly intricate role in various aspects of the financial world. The risk-free rate of return is one of the most basic components of modern finance. Many of the most famous theories in finance—the capital asset pricing model (CAPM), modern portfolio theory (MPT), and the Black-Scholes model—use the risk-free rate as the primary component from which other valuations are derived. It acts as a benchmark for evaluating investment returns, influencing borrowing and lending decisions, and even impacting economic growth. While influenced by a complex web of factors, the risk-free rate serves as a crucial piece of the financial puzzle, impacting individuals, businesses, and the broader economy alike. Understanding its multifaceted nature allows us to make informed decisions and navigate the ever-changing financial landscape.
Ansh Batra is a Junior Analyst at IFSA Hansraj
Sheilja Bansal is a Junior Analyst at IFSA Hansraj
References
1) NYU Stern School of Business | Full-time MBA, Part-time (Langone) MBA, Undergraduate, PhD, Executive MBA Business Programs. Retrieved March 6, 2024, from https://www.stern.nyu.edu/
2) Investing.com - Stock Market Ǫuotes & Financial News. Retrieved March 6, 2024, from https://www.investing.com/
3) CNBC. Retrieved from https://www.cnbc.com/world/?region=world