Understanding Risk, Return & CAPM
Summary
All Model of risk and return in finance are built around a rate that " The Investors can
make on riskless investment and the risk premium 0r premium that investors
should charge for investing in the the average-risk investment."
In the Capital Assets pricing model (CAPM), Where there is only one sources of the
market-risk capture in the market portfolio, "This risk premium become the premium
that investors would demands when investing in that portfolio.
Before Investing investor are demanded exposure to a specific market risk factor.
Chapter-1
Risk Free Rate
Expected return on the assets as the risk-free rate.
Definitions
Expected return on the assets as the risk-free rate. The expected return on risky
investments are then measured relative to the risk free rate.
With the risk creating an expected risk premium that is added to the risk free rate.
But make an assets the risk free rate?
And What do we do when we can't find such an assets?
In Particular, An Assets is risk free, If we know the expected return on it with
certainty (i.e. Actual return is equal to Expected return)
Under what conditions are an Actual Return is Expected Return?
There are two basis conditions are
No Default risk No Re-Investment
This rule out any security issued by a
private equity. The any security that have a
chance of being risk free are government
security, Not because are better run the
corporations but because they usually
control the printing of currency.
Real versus Nominal Risk-Free Rates
Concepts
When the Inflations are high and unstable, The Valuation are needed to be in real time. It means that cash flows are estimated using
real growth rates, not the inflation-adjusted nominal growth rates.
The Real Risk-Free Rate is the return earned after adjusting for inflation, whereas the Nominal Risk-Free Rate is the return before
adjusting for inflation.
Example: If the nominal rate is 7% and inflation is 4%.
then –
Real risk free Rate=(1.07/1.04)−1 = 2.88%
This means an inflation-indexed Treasury offering a 3% real return would provide approximately a 7% nominal return if inflation is 4%.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are a revolutionary financial
instrument that solves the problem of inflation eroding real returns.
Example: Suppose you purchase $1,000 worth of TIPS with
Key Features of TIPS: a 1% coupon rate.
Principal Adjustment: The principal value of TIPS adjusts according to changes If inflation = 2%, the principal increases to $1,020.
in the Consumer Price Index (CPI). The interest payment becomes: $1,020×1%=$10.20.
Inflation Protection: When inflation rises, the principal value of TIPS also (instead of $10 on the unadjusted principal)
increases. Estimating the Real Risk-Free Rate in the U.S.
Interest Payments: TIPS pay interest at a fixed rate, but this rate is applied to Historically, the United States has experienced stable and low
the adjusted principal. Therefore, interest payments rise with inflation. inflation, so real valuations have been less critical.
Maturity Protection: At maturity, investors receive either the adjusted principal
or the original principal, whichever is higher.
However, in markets where inflation-indexed, default-free securities like TIPS do not exist, the real
risk-free rate can be estimated using two primary arguments.
Argument 1: Capital Flow Theory Argument 2: Growth-Based Approach
This argument assumes that if capital can flow freely across This argument states that when there are frictions or constraints
countries, then real risk-free rates should be equal across all markets. in capital flow, the long-term expected real return in an economy
should be equal to its expected real growth rate.
Logic:
If the real return in one country is higher than in another, investors Logic:
will move their capital to that country to earn better returns. Economies with higher growth potential (such as India) should
have a lower real risk-free rate compared to economies with lower
growth potential (such as Germany).
Application for India
For emerging markets like India, the 10-year government bond yield cannot be directly considered the risk-free rate, because it
includes sovereign default risk.
Therefore, to estimate the true risk-free rate: Risk-Free Rate=India’s 10-Year Government Bond Yield−Default
Spread
This adjustment removes the additional yield that investors demand for the possibility of sovereign default, giving a
more accurate measure of the real risk-free rate applicable to India.
Calculating the Default Spread
The default spread can be estimated in three main ways:
Dollar Bond Approach: The difference between the yield on India’s USD-denominated bond and the yield on a U.S. Treasury bond of
similar maturity.
Rating-Based Approach: Using the default spread corresponding to India’s sovereign credit rating (currently around BBB).
CDS Approach: Subtracting the U.S. Credit Default Swap (CDS) spread from India’s CDS spread to estimate the implied default premium.
Why This Matters
Valuation Accuracy: In high-inflation markets, using nominal rates can lead to overvaluation of assets.
Consistent Discounting: When cash flows are projected in real terms, the discount rate must also be real to ensure
consistency. Using real rates allows for better comparison of investments across different countries.
Inflation Protection: Instruments like TIPS protect investors from inflation risk, which traditional fixed-rate bonds cannot.
Risk Free rates when there is no Default -free entity
There are four alternative in the section following for understand Rf.
1. Local Currency Government Bond
Risk Free rate
If long-term local currency government bonds are traded, their yields can serve as the risk-free rate in that currency. ,
we used the local currency sovereign rating of Baa3 assigned to India by Moody's / S & P.
For Example: 10 Years India government bond has trades 6.504% and India default spread is 2.18%. then,
Rf of India is 6.504-2.18=4.324%.
Country Default Spreads
Where investors can buy insurance again default. The sovereign CDS spread then becomes a market-based estimate of the default
spread for a country. It is nothing Nominal expenses just like processing cost.
For Example: 10 years gov. bond rate is 6.50%. CDS of India is 0.50% (assumption) then,
Rf of India is = 6.50%-0.50%= 6.00% ,
2. Build-up Approach
There are countries where either the government does not issue bonds denominated in the local currency, or these bonds do not trade.
In this Case, One alternative is to build up to a risk free rate from fundamentals.
Build-up risk free rate = Expected inflation + Expected real growth rate
For Example: Expected Growth rate of India is 1.5% and Expected Inflation 6%. Then, Rf
Rf of India in Build -up approach = 6.00%+1.50%= 7.50% ,
3. Derivative Market Approach
This method uses forward exchange contracts to back out the local‐currency risk-free interest rate from known foreign rates.
Gather data
Spot FX rate today (local currency per USD).
Forward FX rate for same maturity.
Foreign risk-free rate (e.g., U.S. Treasury yield).
4. Risk-Free Rate Conversion
This formula shows how to convert a known risk-free rate in a developed market currency (e.g., U.S. dollars) into the risk-free rate for
an emerging market currency (e.g., Egyptian pounds), by adjusting for differences in expected inflation.
Where:
rLocalrLocal = Risk-free rate in the local (emerging market) currency.
rForeignrForeign = Risk-free rate in the foreign (developed market) currency.
Expected InflationLocalExpected InflationLocal = Expected inflation in the local currency.
Expected InflationForeignExpected InflationForeign = Expected inflation in the foreign currency.
Why It Matters
Risk-free rates differ across currencies mainly due to:
Differences in baseline interest rates.
Differences in inflation expectations.
This formula “deflates” the foreign rate by its inflation and “re-inflates” it by the local inflation rate, giving a true comparable
rate in local terms.
Thanks for reading!