What is the risk free rate used in the Eurozone? is it the German?

What is the risk free rate used in the Eurozone?

For example, if the operations are in Belguim, do we use the Belguim bond or the German bond as it's the most risk free bond in the euro area?

Is There a European Risk Free Rate?

There are many factors to consider when determining a risk free rate. In general, you would use a long-term government bond of the country in which the business is located. Other ways of choosing a risk free rate include:

  • If no local treasury bond, then US Treasury rate plus a country risk premium
  • Euro area yield curve for AAA rates countries published by ECB
  • 10 years German bund
  • If 10 year German bund does not reflect the economic reality, you can use the pre QE 5 or 10 year average or do a forward looking average using the yield curve plus a premium
  • Consider the US T-bill with an appropriate premium based on a CDS spread on German/Belgian Sovereign debt

Overall, it depends on what you are trying to measure and assess.

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Comments (20)

Dec 17, 2015

I'm not totally sure, but I'd imagine they'd still use the US 10 year treasury. Just because they're in Europe doesn't mean they can't invest in US bonds. Might be wrong though, because you'd have to take into account repatriation taxes perhaps.

    • 2
Dec 17, 2015

I meant that the firm has all of its operations in Belgium, so its not exposed to US market and Treasury rates wont be relevant i guess.
In case there exist no local treasury bond, then US Treasury rates would be used as basis + country risk premium to determine a risk free rate for the country in question.

This is only my understanding, I hope an industry professional would give their feedback

    • 1
Dec 18, 2015

I believe you can base it on Euro area yield curve for AAA rates countries published by ECB or simply can use German bund

Dec 18, 2015

10 years German bund is around what now 0.6% or so ? If you believe it is not realistic and rates do not reflect the economic reality you can use the pre QE 5 or 10 year average or do a forward looking average using the yield curve plus a premium

Dec 18, 2015

Consider the US T-bill with an appropriate premium based on a CDS spread on German/Belgian Sovereign debt. There are many ways to slice this pie.

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Dec 18, 2015

What is the risk free rate used in the Eurozone?
For example, if the operations are in Belguim, do we use the Belguim bond or the german bond as its the most risk free bond in the euro area

Thank you

Disclaimer: i'm a prospective monkey and have no real finance background yet. I'm looking for an analyst intern role so it's nice to participate and learn more on technical threads

The Discount rate you are supposed to use is meant to be the best available opportunity which has a similar systematic risk.
The risk free rate captures systematic risk data such as Country political risk and FX risk.
So you can't use the german or US bonds because even tho the investors have access to them (adjusting for any taxes) the systematic risks are not the same.
so i believe using the belgian one would be more accurate, especially if you are a European(non uk) investor.
However if these investors are based in the US i think you should look at adding a discount because the US capital market has more width (More diversification opportunities) but also more depth (More Capital). In order to find out this discount i think analyzing the required return on belgian companies listed in the US may be interesting.

Dec 19, 2015

It really depends on the value you want to reach... generally, if the country is in the Euro Zone and it is not exposed to particular market risk at that point in time (i.e. Spain, Portugal, Ireland, Italy in 2011-2012 were), you use the 10-yr Gov Bond of that country.
Banks also have their internal model which may provide you a country risk spread, if necessary. As of now, Euro Zone countries do not have a country risk spread to be added to the risk free rate.

You may also do this with the US one but it would reflect the FX risk if your operations are in another currency.

Dec 19, 2015

you must be compenstated for the risk you are taking since when the rf rate increases you can earn a higher return in a security without risk such as a 3 month t-bill

Dec 19, 2015

Equity decreases when Rf rises as interest obligations on debt increase. This volatility is protected by call.
Look at it another way. Due to convexity when interest rates fall volatility decreases on call, and when interest rates rise, volatility increases. Draw the curve to confirm.
So the reason is convexity.

Dec 19, 2015

Check out page 12 and 13 of this Damodaran paper. Should do a good job of answering your questions.

http://people.stern.nyu.edu/adamodar/pdfiles/paper...

Dec 19, 2015

Thank you rcm!

I was actually reading that paper and felt that Damodaran did not explain that section in detail. For example, he just says that the difference is because of the difference in expected inflation for each currency. However, he does not explain in detail how the expected inflation impacts the bond prices.

However, I think I understand it now after reading the paper again. I think the explanation of the impact of expected inflation would go something like this: If in the US the public and/or the Federal Reserve expects inflation to move one way or the other, they will use monetary policy to address that expectation. Therefore, the policy they choose and the interest rates they target/choose will impact the supply and demand on the bonds leading to a price. However, if in the UK, they have different expectations of inflation based on their unique economy their actions will be different and therefore their prices will be different.

Does that sound right?

Matthew

Dec 19, 2015

Doing a little more research I found an article (I don't have enough points to post a link. However, here is a quote from the article that sums it up:

"Fixed-income securities in foreign countries that yield more than the U.S. usually do so for a reason - their inflation rates are higher, which causes their currency to depreciate in relation to the U.S. dollar. Under the theoretical principle of "interest rate parity," the difference in interest rates between countries should be offset entirely by the difference in inflation rates."

Thanks again for pointing me in the right direction!

Matthew

Dec 19, 2015

If the company's main operations are in Brazil but it is traded on let's say NYSE, use the U.S Government Treasuries as your risk free rate. The equity risk premium is where you account for the potential volatility the market prices in for emerging markets.

Dec 19, 2015

http://en.wikipedia.org/wiki/Capital_asset_pricing...

Just add it on top of everything else (still should use US bonds for the risk-free rate).

The estimate for sovereign risk premium can be inferred from market valuations of comparable companies in Brazil vs "risk-free" geographies.

Dec 19, 2015

Thanks for all the help.

Just to clarify, how do you infer the sovereign risk prem from the market valuations exactly? The lower the relative valuation in Brazil, the higher the sovereign risk premium should be? (I'm assuming sovereign risk prem is the addtl company specific risk factor as mentioned in wiki)

Also, for the general market premium part (Rm - Rf), seeing that I used US bonds for Rf, should i use the S&P as a proxy for Rm? or Brazil's stock exchange

Dec 19, 2015

I think Investment Valuation: Tools and Techniques for Determining the Value of Assets by Aswath Damodaran covers exactly what you are asking. Search for "Should there be a country risk premium" - i think the section covering this topic can be read on google books (p. 166 - ).

Dec 19, 2015