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”
“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.”
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