3.3 Calculating a risk-free rate
Complete the activity below to calculate a risk-free rate.
Activity 3 Calculating a risk-free rate
Question 1
You are considering investing in an Indian company, in rupees.
Calculate a risk-free rate using:
- a.Bloomberg, which gives you the following figures for India:
- Return on the market = 13%
- Equity risk premium = 5%
- b.information given by a US bond rating agency about an Indian government bond, as follows.
The Indian government has a rupee-denominated bond that currently yields 14%. The US bond-rating agency (Standard and Poor’s) has given this bond a rating of A. The current spread over a risk-free rate, for an A-rated country, is 6%.
1. Estimate the rupee risk-free rate.
Hint: to arrive at a suitable risk-free rate, deduct the bond risk premium (6%) from the bond yield.
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Using Bloomberg
The risk-free rate = 0.13 – 0.05 = 0.08 or 8%.
Using the Indian bond market and US rating agency
The risk-free rate = 0.14 – 0.06 = 0.08 or 8%.
According to Standard and Poor’s, Indian government bonds have a risk premium of 6% above the risk-free rate.
Question 2
Government bonds are rated in the same ways as corporate bonds. In 2010, Greek ratings had a rating of BB+ compared to AAA for a US bond. Can you think why the ratings are different?
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In 2010, Greece had a higher default risk than the United States.
Standard & Poor’s website [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] provides more information on credit rating and definitions.
Point to note…
Credit ratings are indicative of default probabilities. So, a corporate bond rated ‘AA’ is viewed by Standard & Poor’s as having a higher credit quality and less likelihood of default than a corporate bond with a ‘BBB’ rating. See Standard & Poor’s website for rating definitions.