Finance Mecury Book Value How to Calculate It and Hot to Do It

Discussion Issues and Derivations

Riskfree Rate

1. Estimating the riskfree rate when the government is not default free

We have implicitly assumed in our discussion of risk free rates that the government is a default-free entity and that it issues long term bonds. There are a number of economies where one or both of these assumptions can be challenged. In some emerging market countries, where governments in the past have failed to meet their promised obligations, the government is not viewed as default free. There are many other markets where the government does not issue long term bonds, and the best that one can obtain is a short term government rate.

There are three solutions to this problem. One is to bypass it entirely by doing the analysis in a different currency (such as the U.S. dollar) where a riskfree rate is easy to obtain. The other is to find the rate at which the largest and safest corporations in that country can borrow long term at in the local currency and reduce that rate by a small default premium (say 20 or 30 basis points) to arrive at a long term riskfree rate. The third solution exists only if there are long term forward contracts on the local currency.Since interest rate parity drives forward contract pricing, the long term local currency rate can be obtained from the price of the forward contract and the long term interest rate on the foreign currency.

2. Real versus Nominal Riskfree Rates

Real riskfree rates do not include a premium for expected inflation and should be used if the cash flows are estimated using a similar premise. In practice, it is a good idea to steer away from nominal cash flows and discount rates when inflation hits double digits. One solution is to use a different currency which is more stable; in high-inflation economies, it is common to do investment analyses and valuations in U.S. dollars. The other is to use real cash flows and discount rates.

Obtaining real riskfree rates can be trivial if a...