Sovereign Ratings, Default Risk and Markets: The Moody's Downgrade Aftermath!

 I was on a family vacation in August 2011 when I received an email from a journalist asking me what I thought about the S&P ratings downgrade for the US. Since I stay blissfully unaware of most news stories and things related to markets when I am on the beach, I had to look up what he was talking about, and it was S&P's decision to downgrade the United States, which had always enjoyed AAA, the highest sovereign rating  that can be granted to a country, to AA+, reflecting their concerns about both the fiscal challenges faced by the country, with mounting trade and budget deficits, as well as the willingness of its political institutions to flirt with the possibility of default. For more than a decade, S&P remained the outlier, but in 2023, Fitch joined it by also downgrading the US from AAA to AA+, citing the same reasons. That left Moody's, the third of the major sovereign ratings agencies, as the only one that persisted with a Aaa (Moody's equivalent of AAA) for the US, but that changed on May 16, 2025, when it too downgraded the US from Aaa (negative) to Aa1 (stable). Since the ratings downgrade happened after close of trading on a Friday, there was concern that markets would wake up on the following  Monday (May 19) to a wave of selling, and while that did not materialize, the rest of the week was a down week for both stocks and US treasury bonds, especially at the longest end of the maturity spectrum. Rather than rehash the arguments about US debt and political dysfunction, which I am sure that you had read elsewhere, I thought I would take this moment to talk about sovereign default risk, how ratings agencies rate sovereigns, the biases and errors in sovereign ratings and their predictive power, and use that discussion as a launching pad to talk about how the US ratings downgrade will affect equity and bond valuations not just in the US, but around the world.

Sovereign Defaults: A History

    Through time, governments have often been dependent on debt to finance themselves, some in the local currency and much in a foreign currency. A large proportion of sovereign defaults have occurred with foreign currency sovereign borrowing, as the borrowing country finds itself short of the foreign currency to meet its obligations. However, those defaults, and especially so in recent years, have been supplemented by countries that have chosen to default on local currency borrowings. I use the word "chosen" because most countries  have the capacity to avoid default on local currency debt, being able to print money in that currency to pay off debt, but chose not to do so, because they feared the consequences of the inflation that would follow more than the consequences of default.

BoC/BoE Sovereign Default Database

While the number of sovereign defaults has ebbed and flowed over time, there are two points worth making about the data. The first is that, over time, sovereign defaults, especially on foreign currency debt, have shifted from bank debt to sovereign bonds, with three times as many sovereign defaults on bonds than on bank loans in 2023. The second is that local currency defaults are persistent over time, and while less frequent than foreign currency defaults, remain a significant proportion of total defaults.

    The consequences of sovereign default have been both economic and political. Besides the obvious implication that lenders to that government lose some or a great deal of what is owed to them, there are other consequences. Researchers who have examined the aftermath of default have come to the following conclusions about the short-term and long-term effects of defaulting on debt:

1. Default has a negative impact on the economy, with real GDP dropping between 0.5% and 2%, but the bulk of the decline is in the first year after the default and seems to be short lived.
2. Default does affect a country’s long-term sovereign rating and borrowing costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted at least once since 1970 were one to two notches lower than otherwise similar countries that had not defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to 1% higher than countries that have not defaulted. Here again, though, the effects of default dissipate over time.
3. Sovereign default can cause trade retaliation. One study indicates a drop of 8% in bilateral trade after default, with the effects lasting for up to 15 years, and another one that uses industry level data finds that export-oriented industries are particularly hurt by sovereign default.
4. Sovereign default can make banking systems more fragile. A study of 149 countries between 1975 and 2000 indicates that the probability of a banking crisis is 14% in countries that have defaulted, an eleven percentage-point increase over non-defaulting countries.
5. Sovereign default also increases the likelihood of political change. While none of the studies focus on defaults per se, there are several that have examined the after-effects of sharp devaluations, which often accompany default. A study of devaluations between 1971 and 2003 finds a 45% increase in the probability of change in the top leader (prime minister or president) in the country and a 64% increase in the probability of change in the finance executive (minister of finance or head of central bank).

In summary, default is costly, and countries do not (and should not) take the possibility of default lightly. Default is particularly expensive when it leads to banking crises and currency devaluations; the former has a longstanding impact on the capacity of firms to fund their investments whereas the latter create political and institutional instability that lasts for long periods.

Sovereign Ratings: Measures and Process

    Since few of us have the resources or the time to dedicate to understanding small and unfamiliar countries, it is no surprise that third parties have stepped into the breach, with their assessments of sovereign default risk. Of these third-party assessors, bond ratings agencies came in with the biggest advantages:

1. They have been assessing default risk in corporations for a hundred years or more and presumably can transfer some of their skills to assessing sovereign risk.
2. Bond investors who are familiar with the ratings measures, from investing in corporate bonds, find it easy to extend their use to assessing sovereign bonds. Thus, a AAA rated country is viewed as close to riskless whereas a C rated country is very risky. 

Moody’s, Standard and Poor’s and Fitch’s have been rating corporate bond offerings since the early part of the twentieth century. Moody’s has been rating corporate bonds since 1919 and started rating government bonds in the 1920s, when that market was an active one. By 1929, Moody’s provided ratings for almost fifty central governments. With the Great Depression and the Second World War, investments in government bonds abated and with it, the interest in government bond ratings. In the 1970s, the business picked up again slowly. As recently as the early 1980s, only about thirteen  governments, mostly in developed and mature markets, had ratings, with most of them commanding the highest level (Aaa). The decade from 1985 to 1994 added 34 countries to the sovereign rating list, with many of them having speculative or lower ratings and by 2024, Moody's alone was rating 143 countries, covering 75% of all emerging market countries and almost every developed market. 

Not only have ratings agencies become more active in adding countries to their ratings list, but they have also expanded their coverage of countries with more default risk/ lower ratings.  In fact, the number of Aaa rated countries was the same in 1985, when there were thirteen rated countries, as in 2025, when there were 143 rated countries. In the last two decades, at least five sovereigns, including Japan, the UK, France and now the US, have lost their Aaa ratings.  In addition to more countries being rated, the ratings themselves have become richer. Moody’s and S&P now provide two ratings for each country – a local currency rating (for domestic currency debt/ bonds) and a foreign currency rating (for government borrowings in a foreign currency). 

    In assessing these sovereign ratings, ratings agencies draw on a multitude of data, quantitative and qualitative. Moody's describes its sovereign ratings process in the picture below:

The process is broad enough to cover both political and economic factors, while preserving wiggle room for the ratings agencies to make subjective judgments on default that can lead to different ratings for two countries with similar economic and political profiles. The heat map below provides the sovereign ratings, from Moody's, for all rated countries the start of 2025:

Moody's sovereign ratings

Note that the greyed out countries are unrated, with Russia being the most significant example; the ratings agencies withdrew their rating for Russia in 2022 and not reinstated it yet. There were only a handful of Aaa rated countries, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the only Aaa-rated Asian country. In 2025, there have been a eight sovereign ratings changes, four upgrades and four downgrades, with the US downgrade from Aaa to Aa1 as the highest profile change

With the US downgrade, the list of Aaa-rated countries has become shorter, and as Canada and Germany struggle with budget imbalances, the likelihood is that more countries will drop off the list.

Sovereign Ratings:  Performance and Alternatives

    If sovereign ratings are designed to measure exposure to default risk, how well do they do? The answer depends on how you evaluate their performance. The ratings agencies provide tables that list defaults by rating that back the proposition that sovereign ratings and default are highly correlated. A Moody's update of default rates by sovereign ratings classes, between 1983 and 2024, yielded the following:

Default rates rise as sovereign ratings decline, with a default rate of 24% for  speculative grade sovereign debt (Baa2 and below) as opposed to 1.8% for investment grade (Aaa to Baa1) sovereign debt.

    That said, there are aspects of sovereign ratings that should give pause to anyone considering using them as their proxy for sovereign default, they do come with caveats and limitations:

1. Ratings are upward biased: Ratings agencies have been accused by some of being far too optimistic in their assessments of both corporate and sovereign ratings. While the conflict of interest of having issuers pay for the rating is offered as the rationale for the upward bias in corporate ratings, that argument does not hold up when it comes to sovereign ratings, since not only are the revenues small, relative to reputation loss, but a proportion of sovereigns are rated for no fees.
2. There is herd behavior: When one ratings agency lowers or raises a sovereign rating, other ratings agencies seem to follow suit. This herd behavior reduces the value of having three separate ratings agencies, since their assessments of sovereign risk are no longer independent.
3. Too little, too late: To price sovereign bonds (or set interest rates on sovereign loans), investors (banks) need assessments of default risk that are updated and timely. It has long been argued that ratings agencies take too long to change ratings, and that these changes happen too late to protect investors from a crisis.
4. Vicious Cycle: Once a market is in crisis, there is the perception that ratings agencies sometimes overreact and lower ratings too much, thus creating a feedback effect that makes the crisis worse. This is especially true for small countries that are mostly dependent on foreign capital for their funds.
5. Regional biases: There are many, especially in Asia and Latin America, that believe that the ratings agencies are too lax in assessing default risk for North America and Europe,  overrating countries in  those regions, while being too stringent in their assessments of default in Asia, Latin America and Africa, underrating countries in those regions. 

In sum, the evidence suggests that while sovereign ratings are good measures of country default risk, changes in ratings often lag changes on the ground, making them less useful to lenders and investors.

    If the key limitation of sovereign ratings is that they are not timely assessors of country default risk, that failure is alleviated by the development of the sovereign CDS market, a market where investors can buy insurance against country default risk by paying an (annualized) price. While that market still has issues in terms of counterparty risk and legal questions about what comprises default, it has expanded in the last two decades, and at the start of 2025, there were about 80 countries with sovereign CDS available on them. The heat map below provides a picture of sovereign (10-year)  CDS spreads on January 1, 2025:

As you can see, even at the start of 2025, the market was drawing a distinction between  the safest Aaa-rated countries (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or below, and more risky Aaa-rated countries (US, Germany, Canada). During 2025, the market shocks from tariff and trade wars have had an effect, with sovereign CDS spreads increasing, especially in April. The US, which started 2025 with a sovereign CDS spread of 0.41%, saw a widening of the spread to 0.62% in late April, before dropping back a bit in May, with the Moody's downgrade having almost no effect on the US sovereign CDS spread.

The US Downgrade: Lead-in and Aftermath

    With that background on sovereign default and ratings, let's take a look at the story of the moment, which is the Moody's downgrade of the US from Aaa to Aa1. In the weeks since, we have not seen a major upheaval in markets, and the question that we face as investors and analysts is whether anything of consequence has changed as a result of the downgrade.

The Lead-in

    As I noted at the start of this post, Moody's was the last of the big three sovereign ratings agencies giving the United States a Aaa rating, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In fact, the two reasons that both ratings agencies provided at the time of their downgrades were rising government debt and politically dysfunction were also the reasons that Moody's noted in their downgrade. On the debt front, one of the measures that ratings agencies use to assess a country's financial standing is its debt to GDP ratio, and it is undeniable that this statistic has trended upwards for the United States:

The ramping up of US debt since 2008 is reflected in total federal debt rising from 80% of GDP in 2008  to more than 120% in 2024. While some of the surge in debt can be attributed to the exigencies caused by crises (the 2008 banking crisis and the 2020 COVID bailouts), the troubling truth is that the debt has outlasted the crises and blaming the crises for the debt levels today is disingenuous. 

    The problem with the debt-to-GDP measure of sovereign fiscal standing is that it is an imperfect indicator, as can be seen in this list of countries that scored highest and lowest on this measure in 2023:

IMF

Many of the countries with the highest debt to GDP ratios would be classified as safe and some have Aaa ratings, whereas very few of the countries on the lowest debt to GDP list would qualify as safe. Even if it it the high debt to GDP ratio for the US that triggered the Moody's downgrade, the question is why Moody's chose to do this in 2025 rather than a year or two or even a decade ago, and the answer to that lies, I think, in the political component. A sovereign default has both economic and political roots, since a government that is intent on preserving its credit standing will often find ways to pay its debt and avoid default. For decades now, the US has enjoyed special status with markets and institutions (like ratings agencies), built as much on its institutional stability (legal and regulatory) as it was on its economic power. The Moody's downgrade seems to me a signal that those days might be winding down, and that the United States, like the rest of the world, will face more accountability for lack of discipline in its fiscal and monetary policy.

Market Reaction

    The ratings downgrade was after close of trading on Friday, May 16, and there was concern about how it would play out in markets, when they opened on Monday, May 19. US equities were actually up on that day, though they lost ground in the subsequent days:

If equity markets were relatively unscathed in the two weeks after the downgrade, what about bond markets, and specially, the US treasury market? After all, an issuer downgrade for any bond is bad news, and rates should be expected to rise to reflect higher default risk:

While rates did go up in the the first few days after the downgrade, the effect was muddled by the passage of a reconciliation bill in the house that potentially could add to the deficit in future years. In fact, by the May 29, 2025, almost all of the downgrade effect had faded, with rates close to where they were at the start of the year.

    You may be surprised that markets did not react more negatively to the ratings downgrade, but I am not for three reasons:

1. Lack of surprise effect: While the timing of the Moody's downgrade was unexpected, the downgrade itself was not surprising for two reasons. First, since S&P and Fitch had already downgraded the US, Moody's was the outlier in giving the US a Aaa rating, and it was only a matter of time before it joined the other two agencies. Second, in addition to reporting a sovereign rating, Moody's discloses when it puts a country on a watch for a ratings changes, with positive (negative) indicating the possibility of a ratings upgrade (downgrade). Moody's changed its outlook for the US to negative in November 2023, and while the rating remained unchanged until May 2025, it was clearly considering the downgrade in the months leading up to it.
2. Magnitude of private capital: The immediate effect of a sovereign ratings downgrade is on government borrowing, and while the US does borrow vast amounts, private capital (in the form of equity and debt) is a far bigger source of financing and funding for the economy. 
3. Ratings change: The ratings downgrade ws more of a blow to pride than to finances, since the default risk (and default spread) difference between an Aaa rating and a Aa1 rating is small. Austria and Finland, for instance, had Aa1 ratings in May 2025, and their ten-year bonds, denominated in Euros, traded at a spread of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa rating.

Consequences for valuation and investment analysis

   While the immediate economic and financial consequences of a downgrade from Aaa to Aa1 will be small, there are implications for analysts around the world. In particular, analysts will have to take steps when working with US dollars that they may already be taking already when working with most other currencies in estimating basic inputs into financial analysis.

    Let's start with the riskfree rate, a basic building block for estimating costs of equity and capital, which are inputs into intrinsic valuation. In principle, the riskfree rate is what you will earn on a guaranteed investment in a currency, and any risk premiums, either for investing in equity (equity risk premium) or in fixed income securities (default spreads), are added to the riskfree rate. It is standard practice in many textbooks and classrooms to use the government bond rate as the risk free rate, but that is built on the presumption that governments cannot default (at least on bonds issued in the local currency). Using a Aaa (AAA) rating as a (lazy) proxy for default-free, that is the rationale we used to justify government bond rates as riskfree rates at the start of 2025, in Australian, Singapore and Canadian dollars, the Euro (Germany). Swiss francs and Danish krone. As we noted in the first section, the assumption that governments don't default  is violated in practice, since some countries choose to default on local currency bonds, rather than face up to inflation. If that is the case, the government bond rate is no longer truly a riskfree rate, and getting to a riskfree rate will require netting out a default spread from the government bond rate:

Risk free rate = Government Bond rate − Default spread for the government 

The default spread can be estimated either from the sovereign bond rating (with a look up table) or a sovereign CDS spread, and we used that process to get riskfree in rates in a  host of currencies, where local currency government bonds had default risk, at the start of 2025:

Thus, to get a riskfree rate in Indian rupees, Brazilian reals or Turkish lira, we start with government bonds in these currencies and net out the default spreads for the countries in question. We do this to ensure that we don't double count country risk by first using the government bond (which includes default risk) as a riskfree rate and then using a larger equity risk premium to allow for the same country risk.  

    Now that the US is no longer Aaa rated, we have to follow a similar process to get a riskfree rate in US dollars:

• US 10-year treasury bond rate on May 30, 2025  = 4.41%
• Default spread based on Aa1 rating on May 30, 2025  = 0.40%
• Riskfree rate in US dollars on May 30, 2025 = US 10-year treasury rate - Aa1 default spread = 4.41% - 0.40% = 4.01%

This adjustment yields a riskfree rate of 4.01% in US dollars, and it is also built on the presumption that the default spread manifested after the Moody's downgrade on May 16, when the more realistic reading is that US treasury markets have been carrying a  default spread embedded in them for years, and that we are not making it explicit.

    The ratings downgrade for the US will also affect the equity risk premium computations that I use to estimate the cost of equity for companies. As some of you who track my equity risk premiums by country know, I estimate an equity risk premium for the S&P 500, and at least until the start of this year, I used that as a premium for all mature markets (with a AAA (Aaa) rating as the indicator of maturity). Thus, countries like Canada, Germany, Australia and Singapore were all assigned the same premium as that attributed to the S&P 500. For countries with ratings below Aaa, I added an "extra country risk premium"  computed based upon the default spreads that went with the country ratings:

With the ratings downgrade, I will have to modify this process in three ways. The first is that when computing the equity risk premium for the S& P 500, I will have to net out the adjusted riskfree rate in US dollars rather than the US treasury rate, yielding a higher equity risk premium for the US. Second, for Aaa rated countries, to the extent that they are safer than the US will have to be assigned an equity risk premium lower than the US, with the adjustment downward reflecting the Aa1 rating for the US. The third is that for all other countries, the country risk premium will be computed based upon the the their default spreads and the equity risk premium estimated for Aaa rated countries (rather than the US equity risk premium):

How will the cost of equity for a firm with all of its revenues in the United States be affected as a consequence? Let's take three companies, one below-average risk, one average-risk and one above average risk, and compute their costs of equity on May 30, 2025, with and without the downgrade factored in:

As you can see, the expected return on the S&P 500 as of May 30, 2025, reflecting the index level then and the expected cash flows, is 8.64%. Incorporating the effects of the downgrade changes the composition of that expected return, resulting in a lower riskfree rate (4.01% instead of 4.41%) and a higher equity risk premium (4.63% instead of 4.23%). Thus, while the expected return for the average stock remains at 8.64%, the expected return increases slightly for riskier stocks and decreases slightly for safer stocks, but the effects are so small that investors will hardly notice. If there is a lesson for analysts here, it is that the downgrade's effects on the discount rates (costs of equity and capital) are minimal, and that staying with the conventional approach (of using the ten-year US treasury bond rate as the riskfree rate and using that rate to compute the equity risk premium) will continue to work.

Conclusion

    The Moody's ratings downgrade of the US made the news, and much was made of it during the weekend that followed. The financial and economic consequences, at least so far, have been inconsequential, with equity and bond markets shrugging off the downgrade, perhaps because the surprise factor was minimal. The downgrade also has had only a minimal impact on costs of equity and capital for US companies, and while that may change, the changes will come from macroeconomic news or from crises. For the most part, analysts should be able to continue to work with the US treasury rate as a riskfree rate and forward-looking equity risk premiums, as they did before the downgrade. With all of that said, though, the Moody's action does carry symbolic weight, another indicator that US exceptionalism, which allowed the US to take economic and fiscal actions that would have brought blowback for other countries, especially in emerging markets, is coming to an end. That is healthy, in the long term, for both the United States and the rest of the world, but it will come with short term pain.

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In Search of Safe Havens: The Trust Deficit and Risk-free Investments!

In every introductory finance class, you begin with the notion of a risk-free investment, and the rate on that investment becomes the base on which you build, to get to expected returns on risky assets and investments. In fact, the standard practice that most analysts and investors follow to estimate the risk free rate is to use the government bond rate, with the only variants being whether they use a short term or a long term rate. I took this estimation process for granted until 2008, when during that crisis, I woke up to the realization that no matter what the text books say about risk-free investments, there are times when finding an investment with a guaranteed return can become an impossible task. In the aftermath of that crisis, I wrote a series of what I called my nightmare papers, starting with one titled, "What if nothing is risk free?", where I looked at the possibility that we live in a world where nothing is truly risk free. I was reminded of that paper a few weeks ago, when Fitch downgraded the US, from AAA to AA+, a relatively minor shift, but one with significant psychological consequences for investors in the largest economy in the world, whose currency still dominates global transactions. After the rating downgrade, my mailbox was inundated with questions of what this action meant for investing, in general, and for corporate finance and valuation practice, in particular, and this post is my attempt to answer them all with one post.

Risk Free Investments: Definition, Role and Measures

    The place to start a discussion of risk-free rates is by answering the question of what you need for an investment to be risk-free, following up by seeing why that risk-free rate plays a central role in corporate finance and investing and then looking at the determinants of that risk-free rate.

What is a risk free investment?

    For an investment to be risk-free, you have feel certain about the return you will make on it. With this definition in place, you can already see that to estimate a risk free rate, you need to be specific about your time horizon, as an investor. 

• An investment that is risk free over a six month time period will not be risk free, if you have a ten year time horizon. That is because you have reinvestment risk, i.e., the proceeds from the six-month investment will have to be reinvested back at the prevailing interest rate six months from now, a year from now and so on, until year 10, and those rates are not known at the time you take the first investment.
• By the same token, an investment that delivers a guaranteed return over ten years will not be risk free to an investor with a six month time horizon. With this investment, you face price risk, since even though you know what you will receive as a coupon or cash flow in future periods, since the present value of these cash flows, will change as rates change. During 2022, the US treasury did not default, but an investor in a 10-year US treasury bond would have earned a return of -18% on his or her investment, as bond prices dropped.

For an investment to be risk free then, it has to meet two conditions. The first is that there is no risk that the issuer of the security will default on their contractual commitments. The second is that the investment generates a cash flow only at your specified duration, and with no intermediate cash flows prior to that duration, since those cash flows will then have to be reinvested at future, uncertain rates. For a five-year time horizon, then, you would need the rate on a five-year zero default-free zero coupons bond as your risk-free rate.

    You can also draw a contrast between a nominal risk-free rate, where you are guaranteed a return in nominal terms, but with inflation being uncertain, the returns you are left with after inflation are no longer guaranteed, and a real risk-free rate, where you are guaranteed a return in real terms, with the investment is designed to protect you against volatile inflation. While there is an appeal to using real risk-free rates and returns, we live in a world of nominal returns, making nominal risk-free rates the dominant choice, in most investment analysis.

Why does the risk-free rate matter?

    By itself, a risk-free investment may seem unexceptional, and perhaps even boring, but it is a central component of investing and corporate finance:

1. Asset Allocation: Investors vary on risk aversion, with some more willing to take risk than others. While there are numerous mechanisms that they use to reflect their differences on risk tolerance, the simplest and the most powerful is in their choice on how much to invest in risky assets (stocks, corporate bonds, collectibles etc.) and how much to hold in investments with guaranteed returns over their time horizon (cash, treasury bill and treasury bonds).
2. Expected returns for Risky Investments: The risk-free rate becomes the base on which you build to estimate expected returns on all other investments. For instance, if you read my last post on equity risk premiums, I described the equity risk premium as the additional return you would demand, over and above the risk free rate. As the risk-free rate rises, expected returns on equities will be pushed up, and holding all else constant, stock prices will go down., and the reverse will occur, when risk-free rates drop.
3. Hurdle rates for companies: Using the same reasoning, higher risk-free rates push up the costs of equity and debt for all companies, and by doing so, raise the hurdle rates for new investments. As you increase hurdle rates, new investments will have to earn higher returns to be acceptable, and existing investments can cross from being value-creating (earning more than the hurdle rate) to value-destroying (earning less). 
4. Arbitrage pricing: Arbitrage refers to the possibility that you can create risk-free positions by combining holdings in different securities, and the benchmark used to judge whether these positions are value-creating becomes the risk-free rate. If you do assume that markets will price away this excess profit, you then have the basis for the models that are used to value options and other derivative assets. That is why the risk-free rate becomes an input into option pricing and forward pricing models, and its absence leaves a vacuum.

Determinants

    So, why do risk-free rates vary across time and across currencies? If your answer is the Fed or central banks, you have lost the script, since the rates that central banks set tend to be short-term, and inaccessible, for most investors. In the US, the Fed sets the Fed Funds rate, an overnight intra-bank borrowing rate, but US treasury rates, from the 3-month to 30-year, are set at auctions, and by demand and supply. To understand the fundamentals that determine these rates, put yourself in the shoes of a buyer of these securities, and consider the following:

1. Inflation: If you expect inflation to be 3% in the next year, it makes little sense to buy a bond, even if it is default free, that offers only 2%. As expected inflation rises, you should expect risk-free rates to rise, with or without central bank actions. 
2. Real Interest Rate: When you buy a note or a bond, you are giving up current consumption for future consumption, and it is fitting that you earn a return for this sacrifice. This is a real risk-free rate, and in the aggregate, it will be determined by the supply of savings in an economy and the demand for those savings from businesses and individuals making real investments. Put simply, economies with a surplus of growth investments, i.e., with more real growth, should see higher real interest rates, in steady state, than stagnant or declining economies.

The recognition of these fundamentals is what gives rise to the Fisher equation for interest rates or the risk free rate:

    Nominal Risk-free Rate = (1 + Expected Inflation) (1+ Real Interest Rate) -1 (or)

                                            =  Expected Inflation + Expected Real Interest Rate (as an approximation)

If you are wondering where central banks enter this equation, they can do so in three ways. The first is that central banking actions can affect expected inflation, at least in the long term, with more money-printing leading to higher inflation. The second is central banking actions can, at least at the margin, push rates above their fundamentals (expected inflation and real interest rates), by tightening monetary policy, and below their fundamentals by easing monetary policy. Since this is often achieved by raising or lowering the very short term rates set by the central bank, the central banking effect is likely to be greater at the shorter duration risk-free rates. The third is that central banks, by tightening or easing monetary policy, may affect real growth in the near term, and by doing so, affect real rates. 

    Having been fed the mythology that the Fed (or another central bank) set interest rates by investors and the media, you may be unconvinced, but there is no better way to show the emptiness of "the Fed did it" argument than to plot out the US treasury bond rate each year against a crude version of the fundamental risk-free rate, computed by adding the actual inflation in a year to the real GDP growth rate that year:

As you can see, the primary reasons why we saw historically low rates in the 2008-2021 time period was a combination of very low inflation and anemic real growth, and the main reason that we have seen rates rise in 2022 and 2023 is rising inflation. It is true that nominal rates follow a smoother path than the intrinsic risk free rates, but that is to be expected since the ten-year rates represent expected values for inflation and real growth over the next decade, whereas my estimates of the intrinsic rates represent one-year numbers. Thus, while inflation jumped in 2021 and 2022 to 6.98%, and investors are expecting higher inflation in the future, they are not expecting inflation to stay at those levels for the next decade.    

Risk Free Rate: Measurement

    Now that we have established what a risk-free rate is, why it matters and its determinants, let us look at how best to measure that risk-free rate. We will begin by looking at the standard practice of using government bond rates as riskfree rates, and why it collides with reality, move on to examine why governments default and end with an assessment of how to adjust government bond rates for that default risk.

Government Bond Rates as Risk Free

    I took my first finance class a long, long time ago, and during the risk-free rate discussion, which lasted all of 90 seconds, I was told to use the US treasury rate as a risk-free rate. Not only was this an indication of how dollar-centric much of finance education used to be, but also of how much faith there was that the US treasury was default-free. Since then, as finance has globalized, that lesson has been carried, almost unchanged, into other currencies, where we are now being taught to use government bond rates in those currencies as risk-free rates. While that is convenient, it is worth emphasizing two implicit assumptions that underlie why government bond rates are viewed as risk-free:

1. Control of the printing presses: If you have heard the rationale for government bond rates as risk-free rates, here is how it usually goes. A government, when it borrows or issues bonds in its local currency, preserves the option to print more money, when that debt comes due, and thus should never default. This assumption breaks down, of course, when countries share a common currency, as is the case with the dozen or more European countries that all use the Euro as their domestic currency, and none of them has the power to print currency at will. 
2. Trust in government: Governments that default, especially on their domestic currency borrowings, are sending a signal that they cannot be trusted on their obligations, and the implicit assumption is that no government that has a choice would ever send that signal. (Governments send the same signal when they default on their foreign currency debt/bonds, but they can at least point to circumstances out of their control for doing so.)

The problem with these assumptions is that they are at war with the data. As we noted in our country risk discussion, governments do default on their local currency borrowings and bonds, albeit at a lower rate than they do on their foreign currency obligations. 

If you are wondering why a government that has a choice of not defaulting would choose to default, it is worth remembering that printing more money to pay off local currency debt has a cost of its own, since it debases the currency, pushing up inflation. Inflation, especially when it becomes stratospheric, causes investors and consumers to lose trust in the currency, and given a choice between default and debasement, many governments choose the latter.

    Once you open the door to the possibility of sovereign default in a local currency, it stands to reason that a government bond rate in the local currency may not always yield a risk-free rate for that currency. It is also worth noting that until 2008, investors had that door firmly shut for some currencies, believing that some governments were so trustworthy that they would not even consider default. Thus, the notion that the US or UK governments would default on their debt would have been unthinkable, but the 2008 crisis, in addition to the financial damage it created, also opened up a trust deficit, which has made the unthinkable a reality. In fact, you would be hard pressed to find any government that is trusted the way it was prior to this crisis, and that loss of trust also implies that the clock is ticking towards expiration, for the "government bonds are risk free" argument.

When and Why Governments Default

    Now that we have established that governments can default, let’s look at why they default. The most obvious reason is economic, where a crisis and collapse in government revenues, from taxes and other sources, causes a government to be unable meet its obligations. The likelihood of this happening should be affected by the following factors:

1. Concentrated versus Diversified Economy: A government's capacity to cover its debt obligations is a function of the revenues it generates, and those revenues are likely to be more volatile in a country that gets its revenues from a single industry or commodity than it is in a country with a more diverse economy. One measure of economic concentration is the percent of GDP that comes from commodity exports, and the picture below provides that statistic, by country:

   

   Source: UNCTAD

   
   
   As you can see, much of Africa, Latin America, the Middle East and Asia are commodity dependent, effectively making them more exposed to default, with a downturn in commodity prices.
2. Degree of Indebtedness: As with companies, countries that borrow too much are more exposed to default risk than countries that borrow less. That said, the question of what to scale borrowing to is an open question. One widely-used measure of country indebtedness is the total debt owed by the country, as a percent of its GDP. Based on that statistic, the most indebted countries are listed below:
   
   As you can see, this table contains a mix of countries, with some (Venezuela, Greece and El Salvador) at high risk of default and others (Japan, US, UK, Canada and France) viewed as being at low risk of default. 
3. Tax Efficiency: It is worth remembering that governments do not cover debt obligations with gross domestic product or country wealth, but with their revenues, which come primarily from collecting taxes. Holding all else constant, governments with more efficient tax systems, where most taxpayers comply and pay their share, are less likely to default than governments with more porous tax systems, where tax evasion is more the rule than the exception, and corruption puts revenues into the hands of private players rather than the government.

There is a second force at play, in sovereign defaults. Ultimately, a government that chooses to default is making a political choice, as much as it is an economic one. When politics is functional, and parties across the spectrum share in the belief that default should be a last resort, with significant economic costs, there will be shared incentive in avoiding default. However, when politics becomes dysfunctional, and default is perceived as partisan, with one side of the political divide perceived as losing more from default than the other, governments may default even though they have the resources to cover their obligations.

    As a lender to a government, you may not care about why a government defaults, but economic defaults generally represent more intractable problems than defaults caused by political dysfunction, which tend to be solved once the partisan pounds of flesh are extracted. In my view, the ratings downgrades of the US government fall into the latter category, since they are triggered by a uniquely US phenomenon, which is a debt limit that has to be reset each time the total debt of the US approaches that value. Since that reset has to be approved by the legislature, it becomes a mechanism for political standoffs, especially when there is a split in executive and legislative power. In fact, the first downgrade of the US occurred more than a decade ago, when S&P lowered its sovereign rating for the US from AAA to AA+ in 2011, after a debt-limit standoff at the time. The Fitch downgrade of the US, this year, was triggered by a stand-off between the administration and Congress a few months ago on the debt-limit, and one that may be revisited in a few weeks again. 

Measuring Government Default Risk

    With that lead-in on sovereign default risk, let us look at how sovereign default risk gets measured, again with the US as the focus. The first and most widely used measure of default risk is sovereign ratings, where ratings agencies rate countries, just as they do companies, with a rating scale that goes from AAA (Aaa) down to D(default). Fitch, Moody's and S&P all provide sovereign ratings for countries, with separate ratings for foreign currency and local currency debt. With sovereign ratings, the implicit assumption is that AAA (Aaa) rated countries have negligible or no default risk, and the ratings agencies back this up with the statistic that no AAA rated country has ever defaulted on its debt within 15 years of getting a AAA rating. That said, the number of AAA (Aaa) rated countries has dropped over time, and there are only nine countries left that have the top rating from all three ratings agencies: Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore and Australia. Canada is rated AAA by two of the ratings agencies, and after the Fitch downgrade, the US is rated Aaa only by Moody's, whereas the UK is AAA rated only by S&P.

   In a reflection of the times, there have been two developments. The first is that the number of countries with the highest rating has dropped over time, as can be seen in the graph below of countries with Aaa ratings from Moody's: 

Second, even the ratings agencies have become less decisive about what a AAA sovereign rating implies for default risk, especially after the 2008 crisis, when S&P announced that not all AAA countries were equal, in terms of default risk, thus admitting that each ratings class included variations in default risk. 

    If you recognize that default risk falls on a continuum, rather than in the discrete classes that ratings assign, the sovereign CDS market gives you not only more nuanced estimates of default risk, but ones that are reflect, on an updated basis, what investors think about a country's default risk. The graph below contains the sovereign CDS spreads for the US going back to 2008, and reflect the market's reactions to events (including the 2011 and 2023 debt-limit standoffs) over time:

As you can see, the debt-limit and tax law standoffs created spikes in 2011 and 2012, and, to a lesser extent, in early 2023, and that these spikes preceded the ratings changes, and were not caused by them, and that the market very quickly recovered from them. In fact, the Fitch ratings downgrade has barely registered on the US CDS spread, in the market, indicating that investors are neither surprised nor spooked by the ratings downgrades (so far). 

Dealing with Government Default Risk

     No matter what you think about the Fitch downgrade of US government debt, the big-picture perspective is that we are closer to the scenario where no entity is viewed as default-free than we were fifteen years ago, and it may be only a matter of time before we have to retire the notion that government bonds are default-free entirely. The questions for investors and analysts, if this occurs, becomes practical ones, including how best to estimate risk-free rates in currencies, when governments have default risk, and what the consequences are for equity risk premiums and default spreads.

1. Clean up government bond rate

    Consider the two requirements that have to be met for a local-currency government bond rate to be used as a risk-free rate in that currency. The first is that the government bond has to be widely traded, making the interest rate on the bond a rate set by demand and supply in the market, rather than government edict. The second is that the government be perceived as default-free. The Swiss 10-year government bond rate, in July 2023, of 1.02% meets both criteria, making it the risk-free rate in Swiss Francs. Using a similar rationale, the German 10-year bund rate (in Euros) of 2.47% becomes the risk-free rate in Euros. With the British pound, if you stay with the Moody's ratings, things get trickier. The government bond rate of 4.42% is no longer risk-free, because it has default risk embedded in it. To clean up that default risk, we estimated a default spread of 0.64%, based upon UK's rating of Aa3, and netted this spread out from the government bond rate:

Risk-free Rate in British Pounds     

= Government Bond Rate in Pounds - Default Spread for UK = 4.42% - 0.64% = 3.78%

Extending this approach to all currencies, where there is a government bond rate present, we get the riskfree rates in about 30 currencies:

Since the US still preserves a bond rating of Aaa (for the moment), with Moody's, the US treasury rate of 3.77% on July 1, 2023, was used as the riskfree rate in US dollars. 

    As you look at these rates, especially in some emerging market currencies, you should be cautious about the numbers you get, especially since the liquidity is light or non-existent in government bonds in these markets. Thus, it is possible that the Vietnamese Dong has the lowest risk-free rate in the world in mid-2023, among all currencies, or it may reflect distortions in the Vietnamese government bond.   One way to check these riskier rates for reasonableness is to extend on the insight that the key driver of the risk free rate is inflation, and that in a world where capital moves to equalize real returns, the differences in risk-free rates across currencies come from differential inflation In my post on country risk, In fact, as I argued in my post on country risk, you can convert a riskfree rate in any currency into a risk-free rate in another currency by adjusting for the differential inflation between the currencies: 

Thus, using the IMF's forecasted inflation rates for the US (3%) and Vietnam (5.08%), in conjunction with the US dollar risk-free rate of 3.77% on July 1, 2023, yields a Vietnamese Dong risk-free rate of 5.87% (or 5.85% with the approximation).

    If you believe that S&P and Fitch are right on their default risk assessments for the US, and that it should get a rating lower than Aaa (say Aa1), from Moody's, the path to getting a US risk-free rate has an added step. You have to net out the default spread for the US treasury bond rate to get to a risk-free rate:

Riskfree Rate in US dollars = US Treasury Bond Rate - Default spread on US T.Bond

Using the sovereign CDS market's estimate of 0.30% in August 2023, for instance, when the US treasury bond rate hit 4.10%, would have yielded a risk-free rate of 3.80% for the US dollar.

2. Risk Premia

    If you focus just on risk-free rates, you may find it counter intuitive that an increase in default risk for a country lowers the risk free rate in its currency, but looking at the big picture should explain why it is necessary. An increase in sovereign default risk is usually triggered by events that also increase risk premia in markets, pushing up government bond rates, equity risk premiums and default spreads. In fact, if you go back to my post on country risk, it becomes the key driver of the additional risk premiums that you demand in countries:

You will notice that in my July 2023 update, I used the implied equity risk premium for the US of 5.00% as my estimate of a premium for a mature market, and assumed that any country with a Aaa  rating (from Moody's) would have the same premium. 

    Since Moody's remains the lone holdout on downgrading the US, I would use the same approach today, but assuming that Moody's downgrades the US from Aaa to Aa1, the approach will have to be modified. The implied equity risk premium for the US will still be my starting point, but countries with Aaa ratings will then be assigned equity risk premiums lower than the US, and that lower equity risk premium will become the mature market premium, to be used to get equity risk premiums for the rest of the world. Using the sovereign CDS spread of 0.30% as the basis, just for illustration, the mature market premium would drop from 5.00%, in my July 2023 update, to 4.58% (5.00% -1.42*.30%).

When safe havens become scarce...

    During crises, investors seeks out safety, but that pre-supposes that there is a safe place to put your money, where you know what you will make with certainty. The Fitch downgrade of the US, by itself, is not a market-shaking event, but in conjunction with a minus 18% return on the ten-year US treasury bond in 2022, these events undercut the notion that there is a safe haven for investors. When there is no safe haven, market corrections when they happen will not follow predictable patterns. Historically, when stock prices have plunged, investors have sought out US treasuries, pushing down yields and prices. But what if government securities are viewed as risky? Is it any surprise that the loss of trust in governments that has undercut the perception that they are default-free has also given rise to a host of other investment options, each claiming to be the next safe haven. While my skepticism about crypto currencies and NFTs is well documented, a portion of their rise over the last 15 years has been driven by the erosion of trust in institutions. 

Conclusion

    I started this post by noting that we pay little attention to risk-free rates in theory and in practice, taking it as a given that it is easy to estimate. As you can see from this post, that casual acceptance of what comprises a risk-free investment can be a recipe for disaster. In closing, here are a few general propositions about risk-free rates that are worth keeping in mind:

1. Risk-free rates go with currencies, not countries or governments: You estimate a risk-free rate in Euros or dollars, not one for the Euro-zone or the United States. Thus, if you choose to analyze a Brazilian company in US dollars, the risk-free rate you should use is the US dollar risk free rate, not the rate on Brazilian US-dollar denominated bond. It follows, therefore, that the notion of a global risk-free rate, touted by some, is fantasy, and using the lowest government bond rate, ignoring currencies, as an estimate of this rate, is nonsensical.
2. Investment returns should be currency-explicit and time-specific: Would you be okay with a 12% return on a stock, in the long term? That question is unanswerable, until you specify the currency in which you are denominating returns, and the time you are making the assessment. An investment that earns 12%, in Zambian Kwacha, may be making less than the risk-free rate in Kwachas, but one that earns that same return in Swiss Francs should be a slam-dunk as an investment. In the same vein, an investment that earns 12% in US dollars in 2023 may well pass muster as a good investment, but an investment that earned 12% in US dollars in 1980 would not (since the US treasury bond rate would have yielded more than 10% at the time).
3. Currencies are measurement mechanisms, not value-enhancer or destroyers: A good financial analysis or valuation should be currency-invariant, with whatever conclusion you draw when you do your analysis in one currency carrying over into the same analysis, done in different currencies. Thus, switching from a currency with a high risk-free rate to one with a much lower risk-free rate will lower your discount rate, but the inflation differential that causes this to happen will also lower your cash flows by a proportional amount, leaving your value unchanged.
4. No one (including central banks) cannot fight fundamentals: Central banks and governments that think that they have the power to raise or lower interest rates by edict, and the investors who invest on that basis, are being delusional. While they can nudge rates at the margin, they cannot fight fundamentals (inflation and real growth), and when they do, the fundamentals will win.

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January 2018 Data Update 4: The Currency Conundrum

There is perhaps no more mangled nor misunderstood part of financial analysis than the handling of currencies, and globalization has only made the problems worse. From the laziness of assuming that government bond rate in a currency is always the risk free rate in that currency, to nonsensical notions like a global risk free rate, to bad practices like discounting peso cash flows with dollar discount rates, the list of currency sins is long. In this post, I look at three of the most common misconceptions related to currencies and use them to update currency related numbers at the start of 2018.

Misconception 1: Governments are Default Free (when they borrow in the local currencies)

I was taught, in my first finance class, to use the US treasury bond rate as the risk free rate, when estimating expected return, reflecting the dollar-centric world of my MBA studies. The notion, though, that the government bond rate, denominated in the local currency, is the risk free rate in that currency persists, albeit expanded to include other currencies. Thus, we are told to use the Brazilian Government $R bond as the $R risk free rate and the Indian Rupee Government bond rate as the Indian Rupee risk free rate. Its proponents argue that governments control the printing of money and hence never have to default, but what they fail to note is that in the last three decades, a significant proportion of all sovereign defaults have been local currency defaults; of the 58 sovereign defaults between 1996 and 2012, 31 were in the local currency. As to why countries would choose to default in the local currency, when they can print enough money to pay off debt, the answer is straight forward. Printing more money debases your currency, and countries, faced with a choice between defaulting and debasing their currencies, often conclude that default is a better option.

So what if sovereigns default on local currency bonds? If a sovereign entity (or government) can default on local currency debt, it stands to reason that the rate on a bond issued by it is no longer a risk free rate. Using that government bond rate, as if it were a risk free rate, can lead to the double counting of risk, especially if analysts use a higher equity risk premium to capture additional country risk. For instance, consider the Nigerian Naira 10-year government bond, trading to yield 14.12% on January 1, 2018. If that rate is used as the risk free rate in Naira for a Nigerian company, in conjunction with a high equity risk premium for Nigeria, you are counting risk twice in your computation, once in your “risky” risk free rate and again in your equity risk premium.  To avoid double counting, you have to cleanse the government bond of default risk and to do so, you have to estimate how much of the interest rate on the bond can be attributed to default risk. There are three ways that you can estimate this default spread, though they all come with a catch.

• Government Bond Spread: The first is to find a US dollar or Euro government bond issued by the sovereign in question and to net out the US Treasury Bond rate or the German Euro bond rate as the risk free rates. 
• Sovereign CDS Spread: The second is to observe the sovereign Credit Default Swap on the sovereign in question, which is a measure of the default spread of the sovereign. 
• Local Currency Rating: The third is to use the sovereign rating estimated by S&P, Moody’s or Fitch for a country and to estimate the typical spread at which other bonds with the same rating trade at. 

With the Nigerian Naira, for instance, you have two choices for the default spread; the first is the sovereign CDS spread for Nigeria, which on January 1, 2018, was 4.68% and the second was the 5.64% spread associated with Nigeria's local currency rating of B2 (from Moody's). Using the latter estimate would yield a risk free rate of 8.48% for the Nigerian Naira:

Risk free Rate in Nigerian Naira (1/1/18) = 14.12% - 5.64% = 8.48%

The problem with all these spreads is that they are dollar-based, not local currency-based, and netting these spreads out from the local currency government bond can create an inconsistency. 

This process of estimating risk free rates in different currencies requires the presence of local currency long term government bonds, a requirement that is met by less than fifty currencies at the start of 2018. I used the sovereign ratings to extract default spreads (the third approach described in the last paragraph) and estimated risk free rates in those currencies in the chart below: 

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There are three obvious points to make. The first is that risk free rates vary across currencies, ranging from less than zero in a handful of currencies (Yen, Swiss Franc, Croatian Kuna) to more than 8% in  others (Nigerian Naira, Turkish Lira and the Venezuelan Bolivar). The second is that for the risk free rates that are negative, it is either because the government bond rate was negative (Swiss Franc or Japanese Yen) or because of the netting out of the default spread from the government bond rate (Croatian Kuna and Hungarian Forint). The third is quality of precision of the risk free rate you get in a currency is only as good as the government bond rate that you start the process with. To the extent that some of the government bond rates on my list do not represent traded bond rates but are government set or manipulated, the rates that emerge from them are flawed. For instance, I don't, for a moment, believe that the risk free rate in Venezuelan Bolivar is less than 10%.

Misconception 2: There is a Global Risk Free Rate 

It is perhaps understandable that an analyst who looks at the differences in rates across currencies, before or after adjusting for default risk, will conclude that since the risk free rate is the lowest of the rates at which an entity can borrow money, the lowest of the rates across currencies, perhaps the Swiss Franc or the Japanese Yen, is the global risk free rate and that all other currencies are risky. That is a dangerous delusion, since there is a simple reason why risk free rates vary across currencies. The risk free rate in a currency is a reflection of expected inflation in that currency, and risk free rates will be higher in high-inflation currencies than in low-inflation ones, and can become negative in deflationary currencies. There are three implications that follow:

1. You cannot blend multiple currencies in the same analysis/valuation: When valuing a company that has operations in many countries and derives its revenues in multiple currencies, you cannot create blended averages of risk free rates or growth rates in different currencies. Doing so would be akin to averaging the temperature in New York (measured in fahrenheit) with the temperature in Frankfurt (measured in celsius) to arrive at an average temperature for the two cities. 

2. If you can estimate the expected inflation rate in a currency, you can estimate a risk free rate in that currency: In fact, the risk free rate in a currency can simply be stated as the sum of the expected inflation rate in that currency and the real interest rate. If you are willing to buy into the notion that the real interest rate around the globe should converge on a  single number (as would be the case, if capital could flow easily across markets), the risk free rate in any currency can then be estimated by using the differential inflation rate between that currency and one where a risk free rate is observable (like the US dollar or the Euro).

Note that there is an approximate version of this rate that can be obtained by adding the differential inflation rate to the US dollar risk free rate. If the risk free rate in US dollars is 2.41%, the expected inflation rate in the US is 1.75% and the expected inflation in India is 6%, the risk free rate in Indian rupees can be written as follows;

Approximate form = 2.41% + (6% - 1.75%) = 6.66%

Precise version = (1.0241) (1.06/1.0175) -1 = 6.68%

There are two advantages to the differential inflation approach. The first is that it does not assume that the government bond is traded and it does not have to deal with the currency mismatch of default spreads in US dollars being netted out against local currency bond rates. The second is that this approach can be extended to almost all currencies, since it is built around expected inflation. I have used IMF estimates of expected inflation in currencies to derive local currency risk free rates in more than 150 currencies in the linked dataset. Incidentally, using expected inflation rates yields a risk free rate in Venezuelan Bolivar of 3814%, a much more believable number given the hyper inflation in that country.
3. Pegged exchange rates may be a delusion: There are some currencies that are pegged to the US dollar and for analysts working with these currencies, it has become standard practice to use the US treasury bond rate as the risk free rate in the currency. The danger, though, is that governments that peg currencies can also unpeg them and the differential inflation approach yields a way of finding out when you should worry. If you have a currency pegged to the US dollar, but the inflation rate in that currency is 4% higher than the US dollar, it is only a question of time before the peg will break. In such cases, it may be prudent to replace the US treasury bond rate with a calculated risk free rate, using the differential inflation. (Warning to Middle Eastern analysts: This will cause a significant markdown in value for your Saudi and Emirate equites, but..)

Misconception 3: Currency Choice can drive your valuation

When valuing a company, analysts often default to valuing it in the local currency, but currency is a choice. I can value Severstal, a Russian steel company, in Russian rubles, US dollars or Euros. At first sight, the fact that risk free rates are lower in US dollars and Euros, relative to the ruble, may seem to suggest that you could inflate Severstal’s value, by switching the valuation currency from rubles to dollars, but you will not. The answer to why lies in the last section, where we noted that risk free rates vary across currencies, because of differential inflation, and tying it in with a simple consistency rule in valuation and capital budgeting: if the cash flows in an analysis are forecast in a specific currency, the discount rate used has to be in the same currency. Consequently, if you value Severstal in Euros, instead of rubles, it is true that your discount rate will be lower (because inflation in the US dollar is lower than in rubles) but it is also true that your cash flows will also grow at lower rates, for the same reason. This is captured in the picture below: 

The proposition that the value of a company should not be a function of the currency that you choose to value that company should also cast as a lie the notion that using an emerging market currency in a valuation brings additional risk into a valuation. If Severstal is a riskier company because of its Russian roots, and it is, that risk premium should be part of the discount rate estimated in US dollar or ruble terms. 

The other push back that you will get is that your views on a currency can cause the value estimated in that currency can diverge. For instance, if you expect the Brazilian Reai to appreciate against the US dollar for the next few years, the value of Embraer will be higher, estimated in $R than in US$. While that is true, the reason for the divergence has nothing to do with the use of the currency and everything to do with bringing your currency views into your valuation. Thus, if the value of Embraer is 20% higher, when you value it in $R than in US$, that 20% difference is entirely due to your view that the $R will strengthen, which if true, you can profit from in simpler and more direct ways than buying Embraer.

One of the most common and deadly mistakes in valuation is mixing different currencies in the same valuation. Valuing an Indian company, by projecting the cash flows in rupees and discounting those cash flows at a US dollar cost of capital, will result in too high a value, since the inflation rate in US$ is significantly lower than the inflation rate in rupees. While that may seem like an obvious mistake, and one easy to avoid, it happens because we are often not explicit about currencies when making estimates. Thus, a US company that estimates a dollar cost of capital for acquiring an Indian company and then obtains expected growth rates for the cash flows from the managers of the Indian company, who naturally think in rupee terms, is setting itself up for the mismatch. 

Conclusion 

If there are lessons to be learned from looking at the dangers of mixing currencies, it is that it is time that we stopped being casual about the currencies that we measure and use in our analysis. At the risk of sounding pedantic, we should never estimate a growth rate, without being explicit about what currency that growth rate is estimated in, or talk about cash flows, without thinking about the inflation that we have embedded in them. 

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Datasets/Spreadsheets

1. Riskfree Rate Estimator (Spreadsheet for estimating riskfree rates)
2. Riskfree Rates in Currencies (using Local Currency Government Bonds)
3. Riskfree Rates in Currencies (using Differential Inflation Rates)

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!