3.2 Choosing a risk-free rate
Complete the activity below to choose a risk-free rate.
Activity 2 Choose a risk-free rate
Question 1
A US analyst is selecting a risk-free rate in order to evaluate a 15-year project located in Brazil. The project’s cash flows are in Brazilian reals.
1. Which risk-free rate would be appropriate: US or Brazilian?
Feedback
The most appropriate risk-free rate is one that reflects the risk of the location (of the project or investment).
Remember that the risk-free rate comprises the time preference rate and the inflation rate. The Brazilian and US economies will have different expectations of inflation and this will be reflected in their risk-free rates. The cash flows from an investment located in Brazil will be influenced by inflation in Brazil. So, use a Brazilian risk-free rate.
Question 2
2. What if the project’s cash flow is in dollars, but the risk of the location stays the same?
Feedback
An alternative approach would be to use a 15-year US Treasury bond yield plus a country risk premium for Brazil.
This approach can be used with Brazilian currency cash flows by converting the project’s cash flows from Brazilian reals to US dollars.
Doing this overcomes the difficulty of obtaining a risk-free rate for a project based in a location where the government does not issue government-backed bonds that would provide a risk-free rate.
Point to note...
Consider the location of the investment.