N for an investment to be riskfree then it has to

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n For an investment to be riskfree, then, it has to have No default risk No reinvestment risk n Thus, the riskfree rates in valuation will depend upon when the cash flow is expected to occur and will vary across time n A simpler approach is to match the duration of the analysis (generally long term) to the duration of the riskfree rate (also long term) n In emerging markets, there are two problems: The government might not be viewed as riskfree (Brazil, Indonesia) There might be no market-based long term government rate (China)
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Aswath Damodaran 7 Estimating a Riskfree Rate n 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. n 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. n Do the analysis in another more stable currency, say US dollars.
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Aswath Damodaran 8 A Simple Test n You are valuing Ambev, a Brazilian company, in U.S. dollars and are attempting to estimate a riskfree rate to use in the analysis. The riskfree rate that you should use is o The interest rate on a Brazilian Real denominated long term Government bond o The interest rate on a US $ denominated Brazilian long term bond (C- Bond) o The interest rate on a US $ denominated Brazilian Brady bond (which is partially backed by the US Government) o The interest rate on a US treasury bond
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Aswath Damodaran 9 Everyone uses historical premiums, but.. n The historical premium is the premium that stocks have historically earned over riskless securities. n Practitioners never seem to agree on the premium; it is sensitive to How far back you go in history… Whether you use T.bill rates or T.Bond rates Whether you use geometric or arithmetic averages. n For instance, looking at the US: Historical period Stocks - T.Bills Stocks - T.Bonds Arith Geom Arith Geom 1928-2000 8.41% 7.17% 6.53% 5.51% 1962-2000 6.41% 5.25% 5.30% 4.52% 1990-2000 11.42% 7.64% 12.67% 7.09%
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Aswath Damodaran 10 If you choose to use historical premiums…. n Go back as far as you can. A risk premium comes with a standard error. Given the annual standard deviation in stock prices is about 25%, the standard error in a historical premium estimated over 25 years is roughly: Standard Error in Premium = 25%/ 25 = 25%/5 = 5% n Be consistent in your use of the riskfree rate. Since we argued for long term bond rates, the premium should be the one over T.Bonds n Use the geometric risk premium. It is closer to how investors think about risk premiums over long periods.
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Aswath Damodaran 11 Country Risk Premiums n Historical risk premiums are almost impossible to estimate with any
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