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Which risk free rate is appropriate?

Which risk free rate for analyzing potential equity investment (specific company shares and not specific time horizon) for portfolio with long time horizon ( >25 years).

Important points are:

  • The portfolio is located in developing and small country  
  • There are 25-30 years government bonds (with relatively high yield) but the market is not liquid and I cannot buy big amount of these bonds. For every new issue (2 per year) there is 3-4 times more demand than offer.
  • There are 10 years bonds with (significant lower yield -1,5-2%), but with reasonably developed market.

If you know any study or theoretical conclusions, please send me the links

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I’d go with LT bond yield as the Rf rate (for any model except Fama French which uses short term bond yield as proxy for Rf), but add several risk premiums to the ERP to account for illiquidity, and sovereign credit risk. I’d add an upper bound and a lower bound for these risk premiums in the model.

i’d take the opposite position and say you have to go with the more liquid part of the curve as it is more representative to true risk free. the fact that the long-end of the curve is illiquid tells you that it is not risk free. i assume the country you’re looking at has a moderate risk of runaway inflation at some point thus why long-term bonds are undeveloped and carry a high yield. this high yield represents risk which is not what you’re going for. in my mind, LT is a cycle or two.

a final note. while using the 10 year is likely the most accurate, if the long-end of the curve is illiquid and this illiquidity represents uncertainty then a true RFR for this country may not exist. food for thought.

The rate that gives you the result you want 

As a norm the best risk free rate is a 10 yr us treasury rate. Us is the worlds currency. Imo we set the rates since we have the most capital and the biggest dicks. But most people consider their risk free rate to be their local currency of where they spend their money.

People quote the 10 year as the best maturity for risk free. But there are actually more 5 year maturities out there. And there are actually more 1 year or less than anything else. You could also argue that it should be less so there is no duration risk. Or match it with your average holding period for stocks which is surprisingly 2 months.

when it comes to things like this I often ask what is the average. Who is there largest market share to determine the answer

I love my cheese. I got to have my cheddar.

I agree that short term rates, especially in hacksaw countries, are the most “risk free” in that place. However, the term segmentation still matters. If you are considering longer term rates like 5y, you can’t assume the short term rates will roll indefinitely. Therefore, you still have to intelligently distinguish between term premium and risk premium. 

The most direct method is probably to find credit default swap data for sovereign debt of various countries. These markets are not uncommon, based on my understanding. If you have such CDS data and term rates, you can easily derive the interest rate without default risk. 

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rawraw wrote:

The rate that gives you the result you want 

Ah good old goal-seek the input till your results break-even.

You should use the 10 year yield (because countries usually have bonds with this duration and its easier after) and the result of your analysis should vary if using correctly a local currecy and substacting the default spread or a US Dollar conversion if done right. 

Aswath Damodaran explain this very well, I encourage you check it out: https://www.youtube.com/watch?v=o5D8F2eec6E&list=PLUkh9m2Borqn0rW96St_MJchWcjbdfWxT&index=5

Default Spraeds, ERP, CRP and Taxes: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Countries ratings: https://www.google.com/search?q=country+sovereign+rating&rlz=1C1SQJL_esUY789UY789&oq=country+sovereign+rating&aqs=chrome..69i57j69i60.3751j0j4&sourceid=chrome&ie=UTF-8

The main concept of the lesson is to be consistent with one currency and dont “double punish” the discount rates.

Hope this helps!