Valuation

1

What is the riskfree rate? A Search for the Basic Building Block

Aswath Damodaran Stern School of Business, New York University adamodar@stern.nyu.edu www.damodaran.com

December 2008

2

What is the riskfree rate? A Search for the Basic Building Block

In corporate finance and valuation, we start off with the presumption that the riskfree rate is given and easy to obtain and focus the bulk of our attention on estimating the risk parameters of individuals firms and risk premiums. But is the riskfree rate that simple to obtain? Both academics and practitioners have long used government security rates as riskfree rates, though there have been differences on whether to use short term or longterm rates. In this paper, we not only provide a framework for deciding whether to use short or long term rates in analysis but also a roadmap for what to do when there is no government bond rate available or when there is default risk in the government bond. We look at common errors that creep into valuations as a consequence of getting the riskfree rate wrong and suggest a way in which we can preserve consistency in both valuation and capital budgeting.

3 Most risk and return models in finance start off with an asset that is defined as risk free, and use the expected return on that asset as the risk free rate. The expected returns on risky investments are then measured relative to the risk free rate, with the risk creating an expected risk premium that is added on to the risk free rate. But what makes an asset risk free? And how do we estimate a riskfree rate? We will consider these questions in this paper. In the process, we have to grapple with why riskfree rates may be different in different currencies and how to adapt our estimates to reflect these differences. We will also look at cases where estimating a riskfree rate becomes difficult to do and the mechanisms that we can use to meet the challenges. We will also look at questionable practices, when it comes...