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May 02

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Would downgraded U.S. debt still proxy the risk free rate?

The “risk free rate of debt” is an important concept in financial theory.  Because no debt is truly risk free, analysts use proxies that are close enough to risk free.  When estimating values in U.S. Dollars, the accepted proxy for the risk free rate is the rate on U.S. Treasuries.  Standard & Poor’s recent prediction that U.S. debt has a one-in-three chance of being downgraded by 2013 might have some searching for a new proxy for the risk free rate.  Is such a search necessary?  If so, where does one turn?

The risk free rate becomes especially important when valuing a future stream of cash flows as if that cash was already in hand.  This concept is called “present value”.  The present value calculation recognizes that future cash is not worth as much as cash in hand today.  This is because cash in hand today can be invested and grown.  If invested, one expects the cash to be worth as much as the future cash by the anticipated cash flow date.   The further into the future one expects cash to arrive, the more the cash should be discounted to arrive at the present-day equivalent.  Likewise, the cash should be discounted even further depending on the uncertainty that the future cash will actually be received (i.e. its risk level).

According to one popular financial model called “the Capital Asset Pricing Model” (CAPM), an analyst can discount an expected cash flow by the risk free rate of debt plus an upward adjustment, the size of which depends on the uncertainty of the expected cash flow.  Numerous other valuation models also utilize the risk free rate of debt.

If S&P or Moody’s downgrades U.S. debt slightly, will it be necessary to seek an alternative proxy for the risk free rate?  Probably not, at least initially.  The reason is that the increased interest rate that results from a one step downgrade, from AAA to AA+, is small. Rates on U.S. debt are only an approximation of the risk free rate and will remain an approximation (just slightly more approximate) if downgraded.

Furthermore, an analyst must consider the alternatives.  If not using the rate on U.S. debt to proxy the risk free rate, one might use the rate on foreign debt issues.  However, relying on rates from foreign debt introduces new complications that may render calculations even less accurate.  When translating the rate on foreign debt to a U.S. dollar risk free rate, the analyst has to adjust for expected inflation differences between the foreign currency and U.S. currency.  This additional estimation introduces the potential for additional error that likely offsets inaccuracies that arise from a one-step downgrade to U.S. debt.

But should analysts be concerned about the possibility that a second downgrade will follow the first downgrade and so on?  Such a scenario is unlikely, at least in the near future.  Japan provides a benchmark for comparison, which S&P downgraded to AA-minus from AA on January 27, 2011.  Regarding Japan’s downgrade, S&P noted:

“The downgrade reflects our appraisal that Japan’s government debt ratios — already among the highest for rated sovereigns — will continue to rise further than we envisaged before the global economic recession hit the country, and will peak only in the 2020s”
Japan’s debt burden (about 115% of GDP) outweighs the U.S. debt burden (about 70% of GDP).  Although S&P predicts little chance of substantial progress on the U.S. deficit before 2013, others are less concerned.  For instance, the Wall Street Journal reported that Kevin Flannigan, Morgan Stanley Global Wealth Management, responded to the S&P downgrade as follows:
“Despite a high budget deficit, US Treasuries are still considered the preferred safe-haven investment on a global scale… With Republicans now in a stronger position in Congress, there is some optimism that the US budget deficit could improve in the next few years, which would satisfy the ratings agencies concerns as well.”
If a search for new risk free rate proxies became necessary, there are plenty of other sovereign debt issuers in the AAA club to consider. A list of S&P’s current AAA countries follows.  Leichtenstein, anyone?
  1. Australia
  2. Austria
  3. Canada
  4. Denmark
  5. Finland
  6. France
  7. Germany
  8. Guernsey
  9. Hong Kong SAR
  10. Isle of Man
  11. Leichtenstein
  12. Luxembourg
  13. Netherlands
  14. New Zealand
  15. Norway
  16. Singapore
  17. Sweden
  18. Switzerland
  19. United Kingdom
  20. USA

About the author

Eric Madsen

Mr. Madsen is a Chartered Financial Analyst (CFA) charterholder and a Manager at Fulcrum Inquiry, a finance and economics consulting firm that performs economic damages analysis involving commercial litigation, financial investigations, business valuations, and forensic accounting. He also holds an MBA from the UCLA Anderson School of Management and a B.S. in Economics. He conducts expert analysis in finance and economics. Mr. Madsen may be contacted at 213.787.4122 or at emadsen@fulcrum.com.

Permanent link to this article: http://betweenthenumbers.net/2011/05/a-new-risk-free-rate-proxy-if-u-s-debt-is-downgraded/

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  2. Bill Perlman

    Eric,

    If you are a holder of US Treasuries, or Treasury backed bonds, do you think that hedging such a portfolio is necessary, and if so, what would the best hedging vehicles/strategy be. (Short EuroDollar Futures, long TBF, ???)

    Thanks

    Bill Perlman
    Fairfield ct

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