Not all risk is created equal…
26
¨ Estimation versus Economic uncertainty
¤ Estimation uncertainty reflects the possibility that you could have the “wrong
model” or estimated inputs incorrectly within this model.
¤ Economic uncertainty comes the fact that markets and economies can change over
time and that even the best models will fail to capture these unexpected changes.
¨ Micro uncertainty versus Macro uncertainty
¤ Micro uncertainty refers to uncertainty about the potential market for a firm’s
products, the competition it will face and the quality of its management team.
¤ Macro uncertainty reflects the reality that your firm’s fortunes can be affected by
changes in the macro economic environment.
¨ Discrete versus continuous uncertainty
¤ Discrete risk: Risks that lie dormant for periods but show up at points in time.
(Examples: A drug working its way through the FDA pipeline may fail at some stage
of the approval process or a company in Venezuela may be nationalized)
¤ Continuous risk: Risks changes in interest rates or economic growth occur
continuously and affect value as they happen.
Aswath Damodaran
26
Risk and Cost of Equity: The role of the marginal
investor
27
¨ Not all risk counts: While the notion that the cost of equity should
be higher for riskier investments and lower for safer investments is
intuitive, what risk should be built into the cost of equity is the
question.
¨ Risk through whose eyes? While risk is usually defined in terms of
the variance of actual returns around an expected return, risk and
return models in finance assume that the risk that should be
rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment
¨ The diversification effect: Most risk and return models in finance
also assume that the marginal investor is well diversified, and that
the only risk that he or she perceives in an investment is risk that
cannot be diversified away (i.e, market or non-diversifiable risk). In
effect, it is primarily economic, macro, continuous risk that should
be incorporated into the cost of equity.
Aswath Damodaran
27
The Cost of Equity: Competing “ Market Risk” Models
28
Model Expected Return Inputs Needed
CAPM E(R) = Rf + b (Rm- Rf) Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
APM E(R) = Rf + Sbj (Rj- Rf) Riskfree Rate; # of Factors;
Betas relative to each factor
Factor risk premiums
Multi E(R) = Rf + Sbj (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
Proxy E(R) = a + S bj Yj Proxies
Regression coefficients
Aswath Damodaran
28
Classic Risk & Return: Cost of Equity
29
¨ In the CAPM, the cost of equity:
Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk
Premium)
¨ In APM or Multi-factor models, you still need a risk
free rate, as well as betas and risk premiums to go
with each factor.
¨ To use any risk and return model, you need
¨ A risk free rate as a base
¨ A single equity risk premium (in the CAPM) or factor risk
premiums, in the the multi-factor models
¨ A beta (in the CAPM) or betas (in multi-factor models)
Aswath Damodaran
29
30 Discount Rates I
The Riskfree Rate
Aswath Damodaran
The Risk Free Rate: Laying the Foundations
31
¨ On a riskfree investment, the actual return is equal to the expected
return. Therefore, there is no variance around the expected return.
¨ For an investment to be riskfree, then, it has to have
¤ No default risk
¤ No reinvestment risk
¤ It follows then that if asked to estimate a risk free rate:
1. Time horizon matters: Thus, the riskfree rates in valuation will
depend upon when the cash flow is expected to occur and will
vary across time.
2. Currencies matter: A risk free rate is currency-specific and can be
very different for different currencies.
3. Not all government securities are riskfree: Some governments
face default risk and the rates on bonds issued by them will not
be riskfree.
Aswath Damodaran
31
Test 1: A riskfree rate in US dollars!
32
¨ In valuation, we estimate cash flows forever (or at
least for very long time periods). The right risk free
rate to use in valuing a company in US dollars would
be
a. A three-month Treasury bill rate (0.06%)
b. A ten-year Treasury bond rate (1.51%)
c. A thirty-year Treasury bond rate (2.0%)
d. A TIPs (inflation-indexed treasury) rate (0.15%)
e. None of the above
What are we implicitly assuming about the US treasury when
we use any of the treasury numbers?
Aswath Damodaran
32
Test 2: A Riskfree Rate in Euros?
33
Aswath Damodaran
33
Test 3: A Riskfree Rate in Indian Rupees
34
¨ The Indian government had 10-year Rupee bonds
outstanding, with a yield to maturity of about 6.45% on
January 1, 2022.
¨ In January 2022, the Indian government had a local currency
sovereign rating of Baa3. The typical default spread (over a
default free rate) for Baa3 rated country bonds in early 2022
was 1.87%. The risk free rate in Indian Rupees is
a. The yield to maturity on the 10-year bond (6.45%)
b. The yield to maturity on the 10-year bond + Default spread (8.32%)
c. The yield to maturity on the 10-year bond – Default spread (4.58%)
d. None of the above
Aswath Damodaran
34
Sovereign Default Spread: Three paths to
the same destination…
35
¨ Sovereign dollar or euro denominated bonds: Find
sovereign bonds denominated in US dollars, issued by an
emerging sovereign.
¤ Default spread = Emerging Govt Bond Rate (in US $) – US
Treasury Bond rate with same maturity.
¨ CDS spreads: Obtain the traded value for a sovereign
Credit Default Swap (CDS) for the emerging government.
¤ Default spread = Sovereign CDS spread (with perhaps an
adjustment for CDS market frictions).
¨ Sovereign-rating based spread: For countries which don’t
issue dollar denominated bonds or have a CDS spread,
you have to use the average spread for other countries
with the same sovereign rating.
Aswath Damodaran
35
Local Currency Government Bond Rates – January
2022
36
Govt Bond Rate Govt Bond Rate Govt Bond Rate
Currency Currency Currency
12/31/21 12/31/21 12/31/21
Australian $ 1.67% Indian Rupee 6.45% Qatari Dinar 2.11%
Brazilian Reai 10.31% Indonesian Rupiah 1.02% Romanian Lev 5.21%
British Pound 0.97% Israeli Shekel 1.02% Russian Ruble 8.42%
Bulgarian Lev 0.70% Japanese Yen 0.07% Singapore $ 1.67%
Canadian $ 1.43% Kenyan Shilling 12.55% South African Rand 9.35%
Chilean Peso 5.72% Korean Won 2.26% Swedish Krona 0.21%
2.85% Malyasian Ringgit 3.59% -0.14%
Chinese Yuan Swiss Franc
Colombian Peso 8.14% Mexican Peso 7.56% Taiwanese $ 0.69%
Croatian Kuna 0.63% Nigerian Naira 12.61% Thai Baht 1.95%
Czech Koruna 2.98% Norwegian Krone 1.72% Turkish Lira 23.33%
Danish Krone 0.10% NZ $ 2.33% US $ 1.51%
Euro -0.18% Pakistani Rupee 11.54% Vietnamese Dong 2.12%
HK $ 1.45% Peruvian Sol 5.87% Zambian kwacha 31.50%
Hungarian Forint 4.58% Phillipine Peso 4.90%
Iceland Krona 4.15% Polish Zloty 3.66%
Aswath Damodaran
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Approach 1: Default spread from Government
Bonds
Country $ Bond Rate Riskfree Rate Default Spread
$ Bonds
Peru 3.66% 1.51% 2.15%
Brazil 3.70% 1.51% 2.19%
Colombia 2.33% 1.51% 0.82%
Poland 1.80% 1.51% 0.29%
Turkey 5.43% 1.51% 3.92%
Mexico 2.01% 1.51% 0.50%
Russia 2.48% 1.51% 0.97%
Euro Bonds
Bulgaria 1.00% -0.18% 1.18%
37
Approach 2: CDS Spreads – January 2022
38
Aswath Damodaran
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Approach 3: Typical Default Spreads: January
2022
39
S&P Sovereign Rating Moody's Sovereign Rating Default Spread
AAA Aaa 0.00%
AA+ Aa1 0.34%
AA Aa2 0.42%
AA- Aa3 0.51%
A+ A1 0.60%
A A2 0.72%
A- A3 1.02%
BBB+ Baa1 1.36%
BBB Baa2 1.62%
BBB- Baa3 1.87%
BB+ Ba1 2.13%
BB Ba2 2.56%
BB Ba3 3.06%
B+ B1 3.83%
B B2 4.68%
B- B3 5.53%
CCC+ Caa1 6.38%
CCC Caa2 7.66%
CCC- Caa3 8.51%
CC+ Ca1 10.21%
CC Ca2 12.88%
CC- Ca3 14.50%
C+ C1 15.50%
Aswath Damodaran C C2 17.00%
C- C3 19.00% 39
Getting to a risk free rate in a currency: Example
40
¨ The Brazilian government bond rate in nominal reais on
January 1, 2022, was 10.31%. To get to a riskfree rate in
nominal reais, we can use one of three approaches.
¨ Approach 1: Government Bond spread
¤ The 2032 Brazil bond, denominated in US dollars, has a spread of
2.19% over the US treasury bond rate.
¤ Riskfree rate in $R = 10.31% - 2.19% = 8.12%
¨ Approach 2: The CDS Spread
¤ The CDS spread for Brazil, adjusted for the US CDS spread was
2.72%.
¤ Riskfree rate in $R = 10.31% - 2.72% = 7.59%
¨ Approach 3: The Rating based spread
¤ Brazil has a Ba2 local currency rating from Moody’s. The default
spread for that rating is 2.56%
¤ Riskfree rate in $R = 10.31% - 2.56% = 7.75%
Aswath Damodaran
40
Test 4: A Real Riskfree Rate
41
¨ In some cases, you may want a riskfree rate in real terms
(in real terms) rather than nominal terms.
¨ To get a real riskfree rate, you would like a security with
no default risk and a guaranteed real return. Treasury
indexed securities offer this combination.
¨ In January 2022, the yield on a 10-year indexed treasury
bond was 0.15%. Which of the following statements
would you subscribe to?
a. This (0.15%) is the real riskfree rate to use, if you are valuing
US companies in real terms.
b. This (0.15%) is the real riskfree rate to use, anywhere in the
world
Explain.
Aswath Damodaran
41
No default free entity: Choices with riskfree rates….
42
¨ Estimate a range for the riskfree rate in local terms:
¤ Approach 1: Subtract default spread from local government bond rate:
Government bond rate in local currency terms - Default spread for
Government in local currency
¤ Approach 2: Use forward rates and the riskless rate in an index currency
(say Euros or dollars) to estimate the riskless rate in the local currency.
¨ Do the analysis in real terms (rather than nominal terms) using a
real riskfree rate, which can be obtained in one of two ways –
¤ from an inflation-indexed government bond, if one exists
¤ set equal, approximately, to the long term real growth rate of the economy
in which the valuation is being done.
¨ Do the analysis in a currency where you can get a riskfree rate, say
US dollars or Euros.
Aswath Damodaran
42
43
0.00%
5.00%
-5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
Euro
Swiss Franc
Japanese Yen
Danish Krone
Swedish Krona
Aswath Damodaran
Croatian Kuna
Taiwanese $
Bulgarian Lev
Bri tish Pound
Indonesian R upiah
Israeli Shekel
Canadian $
HK $
US $
Si ngapore $
Australian $
Norwegian Krone
Riskfree Rate
Thai B aht
Qatari Dinar
Vi etnamese Dong
Korean Won
NZ $
Chinese Yuan
Czech Koruna
January 2022 Risk free rates
Malyasian Ringgit
Polish Zl oty
Iceland Krona
Default Spread based on rati ng Hungarian Forint
Philli pi ne Peso
Romanian Lev
Chilean Peso
Riskfree Rates in January 2022 : Government Bond Rate
Peruvian Sol
Indian Rupee
Mexican Peso
Colombian Peso
Russi an Rubl e
South African Rand
Brazilian Reai
Pak istani Rupee
Kenyan Shilling
Why do risk free rates vary across currencies?
Nigerian Naira
Turkish Lira
Zambi an k wacha
43
Or across time…
Aswath Damodaran
44
Risk free Rate: Don’t have or trust the
government bond rate?
1. Build up approach: The risk free rate in any currency can be
written as the sum of two variables:
Risk free rate = Expected Inflation in currency + Expected real interest rate
Thus, if the expected inflation rate in a country is expected to be 15% and
the TIPs rate is 1%, the risk free rate is 16%.
2. US $ rate & Differential Inflation: Alternatively, you can scale up
the US $ risk free rate by the differential inflation between the US
$ and the currency in question:
Risk free rateCurrency=
Thus, if the US $ risk free rate is 2.00%, the inflation rate in the foreign
currency is 15% and the inflation rate in US $ is 1.5%, the foreign currency risk
free rate is as follows:
!.!"
Risk free rate = 1.02 !.!"# − 1 = 15.57%
45
One more test on riskfree rates…
46
¨ On January 1, 2022, the 10-year treasury bond rate in
the United States was 1.51%, low by historic standards.
Assume that you are valuing a company in US dollars
then, but are wary about the risk free rate being too low.
Which of the following should you do?
a. Replace the current 10-year bond rate with a more reasonable
normalized riskfree rate (the average 10-year bond rate over
the last 30 years has been about 5-6%)
b. Use the current 10-year bond rate as your riskfree rate but
make sure that your other assumptions (about growth and
inflation) are consistent with the riskfree rate.
c. Something else…
Aswath Damodaran
46
Some perspective on risk free rates
47
Aswath Damodaran
47
Negative Interest Rates?
48
¨ In 2022, there were at least three currencies (Swiss
Franc, Japanese Yen, Euro) with negative interest
rates. Using the fundamentals (inflation and real
growth) approach, how would you explain negative
interest rates?
¤ How negative can rates get? (Is there a bound?)
¤ Would you use these negative interest rates as risk free
rates?
n If no, why not and what would you do instead?
n If yes, what else would you have to do in your valuation
to be internally consistent?
Aswath Damodaran
48
49 Discount Rates: II
The Equity Risk Premium
Aswath Damodaran
II. The Equity Risk Premium
The ubiquitous historical risk premium
50
¨ The historical premium is the premium that stocks have historically
earned over riskless securities.
¨ While the users of historical risk premiums act as if it is a fact (rather than
an estimate), it is sensitive to
¤ How far back you go in history…
¤ Whether you use [Link] rates or [Link] rates
¤ Whether you use geometric or arithmetic averages.
¨ For instance, looking at the US:
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2021 8.49% 6.71% 6.69% 5.13%
Std Error 2.05% 2.17%
1972-2021 8.04% 5.47% 6.70% 4.47%
Std Error 2.44% 2.76%
2012-2021 16.47% 14.39% 15.89% 14.00%
Std Error 3.88% 4.59%
Aswath Damodaran
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The perils of trusting the past…….
51
¨ Noisy estimates: Even with long time periods of history,
the risk premium that you derive will have substantial
standard error. For instance, if you go back to 1928
(about 90 years of history) and you assume a standard
deviation of 20% in annual stock returns, you arrive at a
standard error of greater than 2%:
Standard Error in Premium = 20%/√90 = 2.1%
¨ Survivorship Bias: Using historical data from the U.S.
equity markets over the twentieth century does create a
sampling bias. After all, the US economy and equity
markets were among the most successful of the global
economies that you could have invested in early in the
century.
Aswath Damodaran
51
Risk Premium for a Mature Market? Broadening
the sample to 1900-2017
52
Aswath Damodaran
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