The risk free rate in given economy is 5% and the expected rate of return on the market is 10 % . I am buying a firm with a perpetual annual cash flow of rs 2000 . If I think the beta of firm is 0.8 when the beta infacy 1.6 . How much will I offer for the firm than it is really worth
Answers
Answer:
6
Interest Rate$
= Interest rate in US dollars
For instance, if the current spot rate is 38.10 Thai Baht per US dollar, the ten-year
forward rate is 61.36 Baht per dollar and the current ten-year US treasury bond rate is
5%, the ten-year Thai risk free rate (in nominal Baht) can be estimated as follows.
61.36 =(38.1)
1+Interest RateThai Baht
1+0.05
10
Solving for the Thai interest rate yields a ten-year risk free rate of 10.12%. The
biggest limitation of this approach, however, is that forward rates are difficult to
obtain for periods beyond a year4 for many of the emerging markets, where we would
be most interested in using them.
• You could adjust the local currency government borrowing rate by the estimated
default spread on the bond to arrive at a riskless local currency rate. The default
spread on the government bond can be estimated using the local currency ratings5 that
are available for many countries. For instance, assume that the Indian government
bond rate is 12% and that the rating assigned to the Indian government is A. If the
default spread for A rated bonds is 2%, the riskless Indian rupee rate would be 10%.
Riskless Rupee rate = Indian Government Bond rate – Default Spread
= 12% - 2% = 10%
Equity Risk Premiums
The notion that risk matters and that riskier investments should have a higher
expected return than safer investments to be considered good investments is intuitive.
Thus, the expected return on any investment can be written as the sum of the riskfree rate
and an extra return to compensate for the risk. The disagreement, in both theoretical and
practical terms, remains on how to measure this risk and how to convert the risk measure
into an expected return that compensates for risk. This section looks at the estimation of
4 In cases where only a one-year forward rate exists, an approximation for the long term rate can be
obtained by first backing out the one-year local currency borrowing rate, taking the spread over the one-
year treasury bill rate and then adding this spread on to the long term treasury bond rate. For instance, with
a one-year forward rate of 39.95 on the Thai bond, we obtain a one-year Thai baht riskless rate of 9.04%
(given a one-year T.Bill rate of 4%). Adding the spread of 5.04% to the ten-year treasury bond rate of 5%
provides a ten-year Thai Baht rate of 10.04%.