Risk free rate in an emerging market
Hi guys,
I am having a hard time in understanding how we determine risk free rates for an emerging financial market. Say we try to value a company in this Banana Republic and need to use the risk free rate to find cost of equity and WACC etc...
Assume there's no risk free, AAA rated sovereign in this country and no long term (i.e. 30 year) zero coupon bonds issued in the local currency.
How do you go about finding the risk free rate ? Can experienced bankers shed some light on it?
Thanks a million!
US treasury is the risk free rate rate.
Take the US long bond as a proxy and just add a risk premium to it, and use that as the risk free rate.
The risk premium can be found using a few different sources. In general, some countries just have a standard number that banks add on to the risk free rate (1.5-3%, maybe a tad higher for a legit Banana republic).
Others try to work through using some ratios, such as assigning each economy a Beta based on the US markets, and using a ratio found from that in order to approximate the risk premium (say, a 1% risk premium for a Mexican company becomes a 1.5% risk premium for Argentina if its twice as volatile). Of course, what data you use varies. And of course, given that the VARS and whatnot were at record levels this year due to unprecedented volatility, using pre-2007 templates for calculating risk premiums might not be the best.
This is just what I've seen in my limited valuation experience, so if anyone has a more detailed or correct answer I would listen to that.
[quote=big unit]Take the US long bond as a proxy and just add a risk premium to it, and use that as the risk free rate.
No, this represents a risky yield (it incorprates a risk premium).
AGain, you use the US treasury yield. Remeber that we use the US yield because it (supposedly) represents the return on a default free, highly liquid asset. People tend to think that the risk free rate is just the government yield in whichever country you live in.
If you invested in Russia, would you use russian gov yields as the rf rate, even though they've defaulted before?
Look it up. They have that data on BLOOMBERG.
I could be wrong, but I believe that the U.S. Treasury rate (10-year bond?) is the standard world risk-free rate. The only adjustment for other nations is currency exchange rate.
Thanks everyone for the valuable input.
Joemontana, I understand what you mean, but dont we need to find the risk-free rate in the currency your company operates?
If we are valuing a Mexican company, we should use risk free rate in pesos I believe. And Virginia Tech's point is in that direction I guess. Virginia can you elaborate?
If the country has any publicly traded companies a good place to start so that you have some benchmark is to look at how equity analysts get to their discount rate for companies they cover in that country.
As others have already said, for the risk free rate the 10yr US T bill can be used. The spread on the local govt equivalent (which is why best to use a 10yr) gives some indication of country risk premium.
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