3.1 Finding a risk-free rate
Complete the activity below to find a risk-free rate.
Activity 1 Finding a risk-free rate
Recommend a suitable risk-free rate to a UK analyst for use in arriving at an appropriate discount rate to discount a fourteen-year cash flow.
Hint: look at the UK–GILTS cash market table from the Financial Times [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] which reports prices. Choose a suitable redemption yield (‘Red Yield’) for discounting a ten-year cash flow. This table has market prices from 20 November 2013.
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Use the fourteen-year gilt yield, which is 3.12%. Look for the ‘Red Yield’ or redemption yield, against the Treasury 4.25% 2027 or ‘Tr 4.25pc ‘27’.
We suggest the yield on the 2027 gilt because it shows expectations of the risk-free rate over the next 14 years (from 2013) and we want to evaluate a 14-year cash flow.
The ‘short’ gilt, such as the Treasury 5% 2014, would not be appropriate.
The redemption yield is the yield of the bond when held to maturity or redemption and takes into account the price paid.
The latter offers a redemption yield of 0.81%, showing how the view of UK interest rate expectations is reflected in the yields of gilts (UK government-issued bonds). In January 2011, interest rates were expected to increase over a period of time to 2021.
Point to note…
Consider the time period of investment when identifying a suitable risk-free rate.
Also, consider macroeconomic factors. On 20 May 2013, the redemption yield on the 14-year gilt (Treasury 4.25% 2027) was 2.51%. Why?
The lower price was a response to the macroeconomic events in May 2013 and the volatility (creating uncertainty for investors) in financial markets, particularly equity markets. The demand for gilts pushed the price of gilts up and the result was falling yields.
Finding a risk-free rate
You can find this information online. By going to the FT markets data web page, you can access a range of archived financial markets data.
Within the data archive section, you can set the category to ‘Bonds & Rates’, set the report to ‘UK Gilts – Cash Market’, and set the date that you want.