The document discusses determining the appropriate risk-free rate (Rf) for valuation purposes. It notes that Rf should represent the rate perceived by marginal investors who only consider systematic risk, as their investments are well-diversified. The three key components in determining Rf are the time horizon of expected cash flows, the relevant currency, and ensuring the government securities being considered are truly risk-free by accounting for any default spread. The document also discusses how inflation should be considered to determine if the Rf is in nominal or real terms.

1. RISK FREE RATE IN VALUATIONS
R(f)

2. In order to understand Risk Free Rate[R(f)] for valuing company/Asset , understanding
Risk is important.
So what is risk in valuation ? Risk through whose eyes ?
While risk is usually defined in terms of the variance of actual returns around an
expected return. Risk should be the risk perceived/determined from the point of view
of Marginal investor pricing the company .
What Marginal investors takes into consideration while valuing the company is only
the Systematic risks in their investments , because their Investments are so well
diversified that unsystematic risks does not considerable effect .
Lets dwell upon this area of risk later in the upcoming posts..

3. Risk Free Rate is the rate where ,Investment's
Expected Return = Actual Return
However for an investment to be Risk Free it has to have
A. No DEFAULT Risk
B. No Reinvestment Risk

4. 3 Components that matter most in determining correct Risk Free Rate
while doing Intrinsic Valuations ;
‡Time Horizon - Risk free rates in valuation will depend upon the expected cash
flow to occur and will vary across time. So 3months R(f) will be different from
10y R(f) and entirely depends only time period of cash flows
‡Currencies Matter – Risk free rate is country specific and is different for
different currencies across the world , I.e $ R(f) is different from INR R(f) .
‡Not all Government securities are Risk free – Since it is general practice for
some analyst to use govt bond rates as risk free rates , some government face
default risk and the rates on the bond will not be risk free. Hence it would not
be ideal to use such rates as R(f) for valuations.

5. General practice across is to use Indian Govt 10 year Treasury Bond Rate as R(f)
but this not the rational practice.
Theoretically ,
10y Treasury Bond rate = 10y YTM of Bond + Default Spread
Therefore
R(f) = 10y Treasury Bond Rate – Default Spread
Lets understand how to calculate Default spread in next slide.

6. 3 approachs to calculate Default Spread:
[a] When Emerging country issues Bonds in US $
In such case Default Spread = Emerging Govt. Bonds rate issued in US $
-
US $ Treasury Bond Rate with same maturity

7. [b] When Emerging country has CDS spreads
In such case Default Spread = Sovereign Credit Default Swap Points

8. [c] When Emerging country neither has CDS spreads nor has issued bonds in
US $ ;
IN such case Default spread = Average spread for other countries with same
sovereign ratings.

9. INFLATION measure on R(f)….!
If the expected cash flows are taken in REAL terms then R(f) should also
be in REAL terms as well and vice-versa.
Conversion of Real data into Nominal data is done using Fisher Effect
formulae which is as under
Real rate = Nominal rate – Expected Inflation rate

10. Nevertheless there is another way of calculating R(f) when countries have not
issued Govt. Securities which happens to one of the metric in deriving R(f).
R(f) of foreign currency = (1+ R(F)of Base currency) * (1 + Expected inflation rate foreign currency) 1
( 1 + Expected inflation rate Base currency)
Where,
Foreign currency= currency of country which has not issued govt bonds/securities
Base currency = currency of US or Europe