Just recently I went for a meeting with a potential client to introduce my services. We were having a brief conversation about the services provided which made him pretty interested in stocks. While discussing returns he asked me “How much do you guarantee on investment?” It brought me back to that finance class, where we used to use this question a lot. But back then it was easy, the answer was found using few numbers and calculations. As the reality struck, it is very well understood that it’s better said than done!
So, what is this guarantee investment or risk free rate as we term it in finance? Risk free rate is the rate which you can make on an investment guaranteed. To most Indians guaranteed investment is that fixed deposit interest that we make on our Banks FD’s. And who would argue that point? I mean who thinks that banks wouldn’t pay back the money? The RBI has gone ahead and declared a few banks like SBI and ICICI too big to fail. And probably they are! But what about the smaller ones?
In the Financial Crisis of 2008, 19 cooperative banks went bankrupt. Last year Fitch even warned about a debt default possibilities in certain mid-sized state-run banks. The point here is that many of these institutions do carry a risk of default. So what is truly risk free?
The answer to that would be sovereign bonds. A government would never default. They could just print more money, however even this notion was challenged by Greece in 2015 when they defaulted on their sovereign bonds.
In valuations, we have a way of calculating the number. When we talk about risk free rates, we talk about no re-investment risk & default risk. Depending on the valuation tenure, you should accordingly choose the sovereign. You cannot choose a 3 year government bond for a 10 year valuation. If your valuation is 3 years, you use the Treasury Bill yield. If your valuation is more than 3 years, use a government bond yield. The Gold Standard of risk free rates are the 10 year government bonds. Here’s a list of all the government bonds that you can use as well as the Treasury Bills. As of this writing the 10 year government bond yield is 7.468%