Risk free rate adjustment
Hi, the risk-free rate of some countries can contain the default expectation (CRP) of the country (like Greece or Italy) and A. Damodaran has the adjustment procedure in his lectures. We subtract the CDS spread or Default spread (dollar denominated) from the YTM of the 10 year country bond. He gives the example of Brazil and I was wondering is it applicable to other countries like Russia or Kazakhstan??? The question is: if the YTM of 10 year bond of my country is not widely traded and just close to the base interest rate and REPO rate, should I do the same procedure as Aswath Damodaran reccommends? It doesn't make sense to me since I don't know whether investors put any expectation of default in the first place. Please, explain it to me.
if he uses it for brazil, I'd imagine the same analysis can be used for other emerging markets
however, the lack of liquidity worries me. is this for homework or something else?
it's for valuation job. I work in Kazakhstan and always wondered whether such adjustment was needed
my gut would be use Aswath's procedure, because while no one likes to think about it, there are only a handful of countries that have a forgettable default risk, and Kazakhstan is not one of them.
another thing to consider is a comparative analysis of bond issues by other former USSR republics and/or middle eastern countries. I believe in the past 15 years Iraq, Egypt, Tajikistan, and others have all come to market. while your economics are different from them, it's a more useful comparison than Brazil, in my opinion.
but the risk free rate is a combination of inflation + real interest rate isn't it? if we assume the inflation of 5% and growth rate of Kazakhstan's GDP for real interest rate of 3.5-4% it equals the YTM of the 10 year bond. If I subtract the CDS spread, the cost of equity would understated, wouldn't it? In case of Brazil, he does that because the inflation + real rate is way lower than the YTM for 10 year gov't bond
so Damodaran assumes that the markup is for the perceived country default rate in Brazil. How can I measure this perception? In other words, how can I know if there is a country default rate in the risk free rate?
in my opinion, the risk free rate is the rate a person earns on capital without being exposed to default risk, e.g. a 90 day treasury bill from the US, switzerland, and maybe japan/germany/UK, so I think you and I are just thinking about this differently.
in theory, some people call the 10y treasury bond of a country as growth + inflation (real GDP growth, that is) so yes, your equation works there. however, I'd argue that embedded within that is an inflation assumption, a term premium, and outside of the safe havens, default risk. so not apples to apples, my friend
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