Does risk free rate compensate for currency risk in equity valuation?

The risk free rate is one of the basic inputs used for company valuation. I have done a bit of thinking on the risk free rate because it poses a number of practical challenges faced by analysts.

For example, when risk free rates are extremely high or extremely low (e.g. government bond yields are fairly low across South Asia at the moment) do we take the current yield or a historical average? If we take an average will it be a 3 year or a 5 year average? In fairly volatile times, the answers to these questions can have pretty large implication for stock valuation.

For the purpose of this post, my focus is more on currency risk. For an investor investing in frontier markets the weakness of the local currency versus his home currency (which is usually USD) can erode the value of his investment. So once we decide a fair value of a company in its local currency do we need to adjust for potential currency depreciation? The short answer to that question is yes, but only under certain circumstances. And that is exactly why investors get scared when they expect a major currency depreciation in a particular country.

But let us rewind for a bit. Lets start with the risk free rate. Why is it that the risk free rate in one country is higher than another country’s even though they are both supposed to be risk free? The explanation for that is that both countries have different inflation expectations. Real risk free rates are supposed to be similar across countries and thus the difference in the nominal risk free rates are caused by only differences in inflation. Now, according to the PPP theory, the long term currency depreciation of one country can be calculated by long term differences in inflation. That means that the risk of future currency depreciation (in a normal situation) is already embedded in the risk free rate (and thus also the discount rates). And if it is embedded we don’t need to adjust the intrinsic value of the company again for currency depreciation.

Wait a minute!!! Didn’t I just say that under certain situations, we DO have to adjust? That particular situation is when a currency is significantly over or undervalued (is in a big disequilibrium). In certain times, currencies in certain countries are grossly overvalued and under a free market mechanism would depreciate. In such situations, the risk free rate differential (aka the inflation differential) would not fully incorporate the currency risk and we need to adjust our estimates of fair values further for the one big depreciation expected to come.

Let us take the example of Nigeria which a lot of people think will see a depreciation of 30-50% (the range is quite wide). Assuming we fall in the more optimistic group and believe in a 30% depreciation. For our valuation purpose, we can value the company using the cost of capital calculated from the local risk free rate and then adjust our value further by an extra 30%.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

5 thoughts on “Does risk free rate compensate for currency risk in equity valuation?

  1. Is PPP theory a valid one for dealing with currencies? I think adjustment of cost of funds may vary to greater extent from country to country, industry to industry & company to company. All entities don’t expose with currency fluctuation in common way. (e.g when a MNC adopts natural hedge).

    1. PPP in my opinion does a fairly decent job of explaining currency depreciation in a longer time horizon. Having said that, even if you don’t believe in PPP, the conclusion that you might need to adjust fair value calculation of a company for big expected depreciation is still valid.

      On the second point, note that choice of the risk free rate is determined by the choice of the operating currency. Two companies operating using the same currency will have to have the same risk free rate used in its cost of capital. If a company located in Bangladesh has revenues in dollars (what you refer to a natural hedge) then we don’t need to use the BDT risk free rate. We can use the USD risk free rate for calculation of its cost of capital as currency risk is eliminated in its cash flow.

      1. Thanks for the reply. It helps.

        In order to value a MNC having a complex group structure (vertical or D-shaped) operated in different regime, what adjustments related to currency are needed for computing cost of capital?

        1. Its a pretty good question. Typically the MNC would be headquartered in a particular country even though they are geographically spread out. Thus the financials statements would be reported in a particular currency also (revenues and expenses from other locations would be converted to home country currency using accounting principles). Thus you just need to forecast cash flows in the home currency and use the home country cost of capital. While forecasting cash flows coming from different regions, you might need to make currency forecasts to convert them back to home country currency if they are a meaningful part of the total income of the MNC. For other smaller contributors explicit currency forecasting might not be required.

          Hope that helps. Just remember one golden rule of any DCF model is that assumptions in numerator (cash flow) and denominator (discount rate) have to be in sync. So if cash flow is in GBP we need to use the British cost of capital. Similarly, if we use an inflation forecast of 5% to forecast revenues, we need to ensure that our risk free rate assumption also builds in a 5% inflation estimate. Otherwise there are serious risks of over or under valuing a company.

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