Session 5: Closure on Riskfree Rates & Equity Risk Premiums

your money goes really to consider um before I ask my usual question just a plea that if you can

remember to bring your name plates it helps me a great deal because I can call in you more easily I know you have a lot on your mind so if you forget it's not a big deal but if you can remember that'll be

great so let me jump to the question that I'm promised you I would ask at the start of every class at least through the first couple of weeks how many of you have not picked a company to Value

yet notice the framing of the question has changed how many of you have not picked a company you do realize that I can look at the master

list and see how many have not picked right so this is like a rhetorical question there are still quite a few of you who haven't picked a company or you haven't end the master list either way

please fix it no because as you will see if you have a company an actual company to work with Things become more tangible right risk-free rates risk premiums betas cost of capital cash flows it's

easier if you actually have a real company to work with rather than abstractions I also want to ask a question about groups I know there are a few people are still struggling to find

groups is there anybody in this class who's not in a group yet I would like the other groups to see if they have room for an extra person because I'm going to put up show up for

adoption here and he's a very good person to have in your group he's promised me pick pick the young high growth money losing company for

you but um please so that's that's the only nudging I can do so hopefully somebody will approach you after this class so let's talk about risk

rates but but today actually as the start of the class I'm going to talk about the thing that we're going to move to after risk rates which is equity risk premiums let me frame what we're trying to

estimate the risk free rate is what you guaranteed to make right and we talked about how to get it for a currency where it's easy maybe the Swiss frank maybe the US dollar and even where it's

difficult the Indian rupe the Brazilian R let's say the risk free rate let's do stay in dollars right now the t- bond rate at the start of today was about 4

and a half% so you can put your money into a t-bond for the next 10 years and you're guaranteed 2 4 and half% with the caveat being that the US Treasury might default but let's keep that out of the

picture 2 half% you know what the equity risk premium is it's what you would demand over and above that 4 and a half% to invest in equities as a

class let's start with the easy part of that question if you can make 4 and a half% guarantee would you demand a higher return or a lower return for investing in equities as a class as an expected return You demand more right

the actual returns might be lower that's a risk but it would be crazy to say I'll take 3 and a half% on stocks if you can make 4 and a half% guarantee the equity risk free is that extra number you would

charge and already you can see why this is going to be so difficult to estimate will it be different across the people in this room and what drives those differences risk aversion if you're more

risk aversion you'll charge a higher Prem doesn't make it right or wrong it's just differences and we're trying to estimate one number for the entire Market think of the millions of people people in this market you can't go

around ask how risk ofe are you how risk ofe are you and then try to figure it out so we' struggled with how best to estimate the number 95% of valuations

here's how that number gets estimated people Look Backwards what does that mean to estimate what you can make over and above the risk free rate you look at 100 Years of stock market history in the US

and you look at what stocks have earned over and above something that you call RIS Treasures for let's say that's 3% say that's what I earned in the last 100

years that's what I can expect to make in the future first when you do this what are you assuming about the future it's going to look like the past it's called mean reversion but you

assume that the past will look like the is that a bad good assumption no don't be so quick to say no because we do this all the time in valuation right we use margins we so if you say no here I'm going to come back and haunt you for the

rest of this class cuz we assume mean reversion some things and we don't assume mean reversion others so let me reframe the question under what conditions is it okay to assume mean

reversion to you long is one condition so that that's a statistical requirement but it's more than just long right for the future to look like the past the system has to be

pretty stable there can't be a structural rate I'll give you an example say you sign Justin berlanda San Francisco

Giants it's legendary pictures one four with five S Young his lifetime erra is like 2 point something which is if you have not not track baseball is a really

good erra and the giant silent historically he's won like 16 to 20 games a season so I'm going to use me R version assume that he's going to win 20 games

next season Jacob what's the problem with my assumption you follow baseball will be unfair to ask you if not I don't follow anybody who's a baseball fan tell me what's get

up there he's 40 years old there's been a structural break right which is at 40 you're fighting all kinds of things you're definitely not

going to be winning 20 games and you could do the soccer play Lion Messi if you sign them on now as bar are you going to go back to the top of the league I don't think so

there's been a structural break mean reversion works until it does it so what's the question I'm asking about the US market is the US Equity Market going forward like the market of the last 100

years or has there been a structural break and I'll give you a clue until 2008 I used to have give leeway to people using historical risk premiums in

the US looking backwards that's you saying what happened in 2008 well that's a question that shouldn't be asked because we know exactly what 2008 brought us it brought us a reminder that

we were in the 21st century it took us eight years into the century say hey you're not in the 20th century anymore that this was no longer an economy where the US was the global economy that we

were truly a global economy everybody locked at the head and that the risk premiums for the last century are probably not the right risk premum for the future even if they

were right for the last century and that's a statistical question Julian raises how do I even know what the risk premium was over the last century there's a statistical question we'll have to examine but there's a structural

question as I said 95% evaluation the assumption is we'll revert back to the past so we're going to start with that process and ask some mechanical

questions about that process but let's say you decide to stay with the status quo estimate a historical risk

rate to get that historical risk premium for the US and I'm going to give you some choices about time periods I want you to tell me what time period you're going to use to get a historical risk premium you could use

just the last year in which case what's your RIS premium going to look like what it stocks through last year Jacob

25% you know what the t- bond rate was last year the return on T bonds was minus 1.6% how did the return become negative last year what happened happened last year to make the t- bond return

negative the coupon rates were positive but the interest rates went up the price of the bond decreased so if I looked at last year Equity risk premum was about

26.6% what's the problem with using that well because last year was a really good year we know you know any sense of Comon that this is not going to be the

case going forward so one year it's too short a period right how about five years or 10 years what's a test of when a period is

long enough that you can trust a number what have we taught in statistics that allows us to gauge the trustworthiness of a number comput you comput but Cycles are

tough to guess in the market right there's a standard error what does it come from how volatile stock returns over time and if stock returns a vol that standard error is going to be large

and the standard error is large I can give you an estimate but if I'm you know following the path of Truth and advertising I have to say this is the range on that

estimate so one year only do five years or do 10 100 years even is not quite enough you're going to see shockingly large standard errors with 100 years so

even if you believe that the future is going to look like the past you're going to run into a second problem I can give you a number but then I'm going to give you a range on that number is so large that you say what am I going to do with

this number I'm starting to dig a hole for historical risk creams that I hope to bury them in but the foundations are first you can't assume the future is going to look like the past and the

second is it's noisy noisy in the sense of big standard errors and there's a third problem with historical R sprs they push in the wrong

direction let me explain what I mean by this let's say 2022 2011 is too far in

the past 2022 was a terrible year for stocks stocks were down about 24% let's assume I'm Computing a

historical risk premium right I computed through 2021 now I had a really bad year for stocks I bring in 2022 into my calculation when I bring in a really bad

year of stock returns what's going to happen to my risk premium is it going to go down or go up it's going you brought a really bad yeah negative number you bring in a negative number your stock

returns are actually going to get lower so your risk premium actually will go down after a terrible year for stocks intuitively think of what I'm asking you to say you're in a crisis stock prices

drop 25% a year I said don't worry things have become much safer use a lower risk premium that's what I mean by pushing in the wrong direction because you think about risk is coming from your

gut my guess is after a really bad year for stocks you're feeling more risk ofs not less risk of ver you should demand a higher premium but historic premiums are

going to push in the wrong direction they're going to push up when you're in a bull market and everybody's optimistic they're going to push down when you're in a crisis and that's not

the direction you want risk premiums to go we've always known this about historical risk premiums but you know the argument that people use for using historical risk premiums is right what

other choice do we have how do we get a forward-looking premium you can't go around asking people people try with survey PR they're so

unreliable so 30 years ago I decided that this wasn't working for me I said I want a forward-looking premium that's Dynamic that changes if I'm in the

middle of a crisis and I stole an idea from the bond market Bond markets are not that creative but this is an idea that I

like let's see how much of your foundations class you remember how do you compute the yield to maturity in a bond diction what's what's a process by which you compute the yield to maturity on a

b the face value and what first before you okay price and face value what else do you look at and coupons During the period so finish the process off I've

got the price I've got the coupons I got the face value what's yeld to maturity it's you bring it back it's that discount rate that makes the present value of the cash

flows there you go it's an internal rate of return for a bond right so I'm going to frame this and I'm going to give you a very simple intuitive way of thinking about Equity risk

BRS so Bradley is going to be my guinea pig today okay so I told you the rates right now 4 and a half% let's round it up to 5% right let's suppose I promised

you a dollar in cash flows every year forever in perpetuity and let's assume that I have an entity that will keep paying it up so even after I pass so if

I offered you a dollar every year in perpetuity guaranteed how much would you pay for that cash flow Stree uh it would be one divided by the discount rate one

divided by 0.05 would give you $20 do you see why $20 would do it because if you took $20 and invested 5% what do you make every year a dollar so basically it

works out so if dollar with certainty every year in perpetuity would give me $20 Julian I'm going to pick on you now so now I'm going to give you the same

cash flow stream a dollar every year but rather than it being guaranteed there's going to be risk in it it's going to be risk associated with the typical Equity investment would you pay less than 20 or

more than 20 for that less than 20 right why $20 for a guaranteed cash flow this is now an uncertain cash flow you're saying I'm

not paying 20 how much less give me a number $5 so think so that's a good good point but the more risk less you'll pay right

so let's suppose this is the collective risk of all equities in the US and it's a subjective number so tell me you know $12 $15 $10 what would you pay

for $13 right once he tells me that he's given me his Equity risk premium do you see why because if you make a dollar every year and you pay $13 one divided by 13 I wish she given me 10 it be a

nice number to work with but you know you pay would be what 7even so basically it's about

7% 7% minus the 5% risk free rate gives you an equity risk premium of 2% if Margaret had told me $10 that's an expected return of 10% the equity risk

PR is 5% you tell me what you pay for something whether you like it or not you've given away your Equity risk premium right the less you pay the higher the risk

premium today we're going to to bring that maybe today I don't know whether you'll get to it we're going to use that same idea to get an equity risk bring for Stocks by doing what do we know what

people pay for stocks every minute of every day right there's the index number right there do we know what expected cash flows are not as easily as the example

that I gave you but we can estimate them because we have history these are 500 if it's S&P 500 there if earnings and cash flows you can project them out and and once I do that I can do

exactly what I did with a bond compute an internal rate of return that makes the present value of the cash flows it's messier than a bond I agree but it's a number that will be forward-looking

because it's based on expected future cash flows and will it be dynamic because every time the stock index changes the risk premium is

changing remember last Monday when we woke up to a tariff news and the index was down 3% when the index drops what's happening to the risk

premium they go up just like bond prices and interest rates that makes complete sense right you walk up to a crisis your risk premium goes up we're moving in the right direction it's going to be forward

forward-looking and dynamic and it's a number that we can track over time so we're jumping ahead to that we'll we'll get to that soon but first I want to wrap up our discussion of risk free

rates now Julian just before the class started you know asked me to mention which packet so let me be clear know the intro packet is done everything we're going to do other than the start of the

class test is going to come from that packet one remember last session we were talking about estimating a risk-free rate in Brazilian

R we have the Government Bond R right you say what if I have a currency with no government bonds we'll talk about that we have a government bond rate but I said you can't use the government bond

rate as your rcre rate why not what because governments have risk right they might not pay you back so what do we have to do we have to take out from the government bond rate what we think

is due to that default risk and I gave you three ways of doing it one is I said if you can find a dollar or a Euro Bond issued by that government you can take

the difference between that rate and the t- bond rate so for the Brazilian government that works out to be 3.17 7% right you subtract the

3.17% from the government bond rate of 12.3% you get a risk free rate of 9.17% that's approach one but the problem with that is government bonds

don't often get traded you might say I don't trust the government bond rate so let's try a second one I talked about the Sovereign CDs Market if you've never heard of it you're not alone lots of

people have it it's a way you buy insurance against default risk it's a market set number that number was

2.82% you subtract that from 12.3% you get a risk-free rate in re of 99.48% already you can say which one should I use hang on I'll give you a third

one I say I don't trust the market I don't trust the Government Bond but I trust the ratings agency a strange place to end up but it

based on its rating the default spre 2.83% you subtract that from the 12.3% if you just had to pick the risk free rate which one's

going to give you the highest value the lowest risk free rate or the highest one looks like the lowest one right see this is great I can pick whatever I want I'm going to say something that's going to sound nonsensical but I'll back it up it

doesn't matter which of the three numbers you pick if you stay consistent because you're going to come back with to this number again later in the calculation I'm not going to be mysterious what are

the three numbers that go into my cost of equity a risk free rate a bet and an equity risk premium right you know what this number is going to come back when I compute the risk premium for Brazil so

if you pick a big default spread here because it gives you a lower risk free rate that same bigger default spread is going to give you a bigger Equity risk premium so it's actually good news

because it means don't pontificate about which number to pick pick one and move on and just remember which one you pick that's the only requirement

it'll get it'll it'll even out so it is true that those numbers could could change but no you can estimate risk in the case of Brazil I had all three in

the case of India I have two out of the three which one is missing I can find a sovereign CDs and I can find a rating but India does not

issue dollar denominated bonds but if I picked um Gambia there are no government bonds you're you're essentially in no

man's land basically because you might not even be able to get a default spread using any of the approaches and maybe if you get a rating that's all you can do so Beggars can't

be choosers the currency you pick there might be only one way just take that and move on with it but if your inflation that's high we talked about the possibility of doing

everything in real terms let's be very clear in what that means when you compute things in real terms you're ignoring inflation it's called constant dollars you're acting like the

only way you'll be able to grow your revenues by selling more items you can do your cash flows in real terms and already you can see real cash flows will generally be lower than noral cash flows

why because inflation is not helping you so by itself you saying this is bad I'm getting lower cash flows but to be consistent then you have to use a real discount rate that has to come from a real risk

rad say how the heck am I going to get a real risk ring for the last 20 plus years and it's only in the last 20 plus years in the US I talked about the tips

rate an inflation protected treasury rate staying with the Assumption the treasury doesn't default here's how the tips Works a tips rate works right now

the tips rate I think is about 2.23% you go by a 10year tips Bond the rate is 2.23% can somebody help me on what

exactly I will make every year on this Bond how does this work go ahead it's the rate plus the it'll be whatever The observed inflation rate so let's say

next year the inflation rate is 3% I will get 2.3 23% plus 3% what if it's 7% I'll get 2.23 + 7% what if it's minus 1%

be 2.23 minus 1% you see what this does right it guarantees you a real rate of return not a ninal return so you could argue it's a real

risk R but I've almost never seen a valuation in the US done in real terms and there's a good reason for that the world

operates in noral terms in fact this April 15 when you file your taxes try this say look I took the income from last year but I inflation adjusted the income I really

didn't make $150,000 in constant 2023 I made only $121,000 I'd like to pay less in

taxes the IRS is going to say that's nice but we tax nominal income the world revolves around nominal numbers so it does make sense to stay with nominal numbers so why would use real numbers

because inflation gets so high and unstable in some countries you finally give up and say I'm going to do everything in real terms Latin America used to be the epicenter for real

analysis because inflation was such a bogey man and I need a real risk free rate for those projects in Venezuela and Honduras

and Brazil and he say can I take the tips rate which is a real risk rate r i get in the US Treasury Market and use it there I'll give you the easy answer first and then I'll give you the

qualifiers yes but only if you assume what what keeps in in an e cont textbook real risk fre rates should actually be the same

around the world because the real risk fre rate in Brazil is 4% it's 2.2% in the US what should happen in that Capital should

flow from don't let's not even use the word arbitrage Capital flow where the real returns are highest so you should have Capital flowing from the US to Brazil which will push the real rate down in

Brazil towards so in a world where there's no limits to Capital flowing and that's obviously utopian world the real risk free rate is a real risk free rate no matter where you are I'm going to hold on to that word

because the alternative to me is terrifying in terms of estimating a real and if you ask me to do a real valuation of a Brazilian company I will start with

the 2.23% tips rate and hope and pray that Capital flows enough for it not to be too different we'll come back and see maybe there's different ways of doing it but

this is the only observable updated real risk free rate you're going to be able to use and I'm going to take it and work with it in spite of its

limitations so let's say I do this the the what I did with the Brazilian re for multiple currencies I they started 2025 here's what the world looked like to me

in terms of risk fre rates so you can see that risk free rates so the way to read this is the height of the column is the government bond rate so let's take

turkey the Turkish Government Bond rate is 27% but there's default risk in Turkey you subtract out that red part is a default risk what you're left with is a risk

free rate in Turkish L of about 22% think just pause and think about what that does right you start with a 22% base and you start adding stuff to

it what's your cost of backp putting Capital going to look like really high numbers yesterday I valued this Turkish company called

Anor in Turkish l so it's an exercise where you're saying will this hold up because you're looking at 30% cost of capital you think about discounting trust me it's going to be okay you can

still value companies with 22 but you can see that risk free rates vary across currencies so I have a very simple question I think we've kind of answered in the last session let's kind of nail

it down remember me again why risk free rates vary cross currency sta why risk free rates why is the risk free rate high in l but remember I cleaned up for the risk

right so if I showed you Government Bond rates that would explain it but if I cleaned up for that risk what's left you want to pass it on what do you

thinking High inflation currencies have high risk free rates low inflation currencies have low risk free rates and deflationary currencies could have what netive negative risk rats we've cracked

the code here that's exactly why currency choice is not going to matter you know Adil came to me at the start of the class and he said I'm valuing a Swiss company in Swiss

fra when I did this swis Frank rate was mildly positive but he said it's turned negative right now by itself if you looked at a negative risk-free rate you're going to end up with a really low cost of

capital but a negative risk free rate goes with deflation and low growth so when you do your cash flows you have to stay with s frack and the way it'll play out is you said there operations were in

the U right so your cash flows are all going to be in US dollars but to do your valuation in Swiss Franks what do you have to do you have to convert dollar cash flows into Swiss frank cash flows and what do you need for that you need

future exchange rates and if your inflation rate is minus. 2% and the inflation rate in the

minus. 2% and the inflation rate in the US is 2.5% is in very general terms what should happen to that exchange

rate that's TR appreciate right it's called purchasing power par it's one of the in fact The Economist used to have this index called the Big Mac index where they used to measure what a Big Mac cost in different parts of the world

it was actually very good predictor what exchange rates would do right so when you forecast the cash flows in Swiss Franks what will happen

is whatever you gain by having a lower discount rate you will lose when you do that conversion because your 7% growth in US Dollars will become a 5% growth grow in Swiss

fracks now do you see why I was okay valueing Anka and Turkish L I did give them Sky High discount rates but when I came to estimating

growth I gave them a 25% growth rate you saying that's absurd for an infrastructure company their real growth is only about 3 or 4% but if you think about the inflation that's embedded in a

22% riskk free rate that inflation is going to make your growth rates also high if you pick a high inflation currency you will have a high discount rate that's a given but if you pick a

high inflation currency you also will have much higher growth rate you can already see the pathway to ruin your is to mix and match if you decide to Value the company

in US Dollars and you leave the growth rate as the US dollar growth rate and you discount it back at a Swiss frank discount rate what are you going to end up finding very high value you're going

to find the company as a very high value for all the wrong reasons conversely if I took a Turkish company estimated the cash flows in dollars and used a

Turkish Le discount rate I will devastate the company mistakes and valuation come from mixing and matching inflation rates different inflation rates in your cash

flows and discount rates and that's what you're trying to avoid so risk-free rates vary across currencies can they vary across time stupid question of course it can

vary across time right the 4.5% you're looking at the t- bond rate remember your project is due May 5th I will make a prediction that I'm willing to put

$10,000 behind that the t- bond rate on May 5th is not going to be 4.5% maybe I shouldn't put 10,000 might end up

there but you see why right it could go up it could go down what causes interest rates to change over

time one more but that's you know kind very because demand so what drives B markets pushing up rates are pushing and please don't say the FED

not no it's actually one thing right it's inflation and real growth it's two things right but basically inflation and real growth drive it inflation goes up a lot

you should expect the t- bond rate to go up a lot it goes down over the period you saying what can cause inflation to collapse there's the co collapse between February 14th and March

20th of 2020 treasury rates in the US imploded they went from 3% down to one and a half they they kind of stayed down

there for a while but what is it about Co that made treasury rates drop so dramatically well remember covid

basically you the economy at least a few was the economy would implode and people would stop buying stuff deflation I mean it turned out in hindsight was complete fantasy

but the market was basically building in those expectations so rates will vary across currencies they'll vary across time don't fight it which fight it in the sense you want

a discount rate you want it to stay locked over the next three months it's not going to happen your rates are going to be moving luckily for you you can make your discounted C you can even put the tond rate as a direct input from

Yahoo finance right so you don't enter the number might not be a bad idea because you can create an Excel spreadsheet that's live then where your valuation gets updated every moment of every

day hopefully not by too much because if a lot is happening then you're having the equivalent of covid and a lot of other things could change as well but interest rates do vary across

time so if you have a currency where there is a Government Bond we at least have a pathway to getting risk free rates right getting defa spread but there are about 120

currencies around the world where there is no Government Bond in that currency doesn't mean those governments don't borrow much of Africa you will not find a 10-year government B outside of

Nigeria and South Africa you're going to have a tough time finding a Government Bond do those governments borrow yes they borrow from the World Bank they borrow from commercial Banks they don't issue

bonds saying how do I get a risk-free rate in those currencies I think we've created the pathway because if differences in risk free rates come from difference in

inflation there's another way to get a risk free rate that doesn't require a Government Bond I'll give you an example 2015 I was valuing an Egyptian Bank why was I I

don't know I was moment of weakness I want to Value Egyptian Bank in Egyptian pounds and I wanted to get a risk-free rate in Egyptian pounds I went looking for a government bond rate in Egyptian

pounds none out there so here's how I proceeded to get the risk free rating pounds and tell me whether you go along with the logic the t- bond rate then was about 2% that's a US you're saying why

are you going to Dollar risk fre rate I'm going to start there and then I estimated two numbers the first was an expected inflation rate in the US which at that time was 1 and a half% and an

expected inflation rate in Egyptian PS which is 15% if I'm in a hurry you know I'm done right because basically to get a risk free rate in Egyptian pounds I'm going

to take the US key bond rate of 2% and add the differential inflation which in this case would be 13 and a half% 2% plus 13 a half% is 15 a half

per. if I wanted to get

per. if I wanted to get fancy maybe to show off risk free rates have this compounding effect inflation and real interest rates compound what does that

mean to get the risk fre rate I'm going to start with one plus the USD bond rate and then take the inflation in the two countries and and subtract out one all

the gymnastics got me to 15.57% now now you see why the approximation works pretty well 155% I could have got there quick lot sooner but it's differential

inflation fact when I showed you that picture with Government Bond there are some Government Bond rates there that I don't quite trust because in much of the world government bonds are not not like T

bonds widely traded they're issued by the government and banks in the country are forced to buy the government bonds at whatever rate the government specifies it's not a market set rate you know how you can check to see whether

you can trust the rate do the differential inflation if the government bond rate is 11% inflation is 30% that Government Bond is not so I actually do this when I get a Government

Bond in a currency that I'm not familiar with just to make sure that that number is even a good starting point this will always work with any currency all you need is the T bond rate or a German Euro

Bond as your starting point and then a differential inflation between that currency and the us if it's dollars or that currency and the Euro if it's German Euro bond rate to get a risk-free

rate in any currency any questions on this I do need two numbers there right the expected inflation in dollars the expected

inflation in Egyptian Parts the expected inflation dollars is easy to get how do I get it difference between the t- bond and the tips right I think we might have

talked about it so the tips the the t- bond rate at the started Z 4.58% the tips rate was 2.23% that's a 2.3 35% difference I'm not going to do

any dances the market gives me that number I'll Trust it a lot more than any macroeconomist giving me a number because there's real money behind this number hundreds of billions trillions of

dollars in t- bonds so they expect inflate yeah isn't one expected and one observe observe no observe what these

are both expectations right the the the tips rate the 2.23% is an expected real interest rate over the next 10 years the t- bond rate is an expected T bond rate

over the next 10 years so what part of that is it's always expected you might use observed inflation as expected why because you get desperate right that's

what we often do and if you ask me to get an expected inflation in Egypt that was my first stop and I went and looked at the observed inflation rate in the most recent year but if you do that you

got to be very clear on why you do I'm going to give you a suggestion on if you want to get an expected inflation in countries we can do it easily and at no

cost that's a big criteria for me if you visit the imfs or the world bank's website they have some really good data it's really difficult to kind of work

with the data because being user friendly is not top of the list of priorities but they actually have expected inflation rates for every country for the next 5 years years not

quite 10 but this 15% came from the imf's forecast of inflation in Egypt for the next 5 years am I happy with it not really but the best I can do but

essentially that's going to drive my risk fre started 2022 and I walked into this class the t- bond rate was 1 and a

half% and one of the lowest rates we'd observed in history in fact come off a decade where rates had been low and it was driving people crazy to

different extents depending on how old they were the first reaction was 1 and a half% is a really low rate can I replace it with something

more normal what is normal you look at an average over the last 10 years 20 years 50 years in fact if you look at the last 30 years the key bond rate is about 5 to six the question is can I

just take the RIS free rate or 1 and a half% and replace with a normalized risk free rate fact Duff and Phelps which are kind of a lot of the appraises depended on suggested this as a practice in the

period of low rates is to take the low rate and replace it with a more normal risk rate some of you young might be trying to think about doing the the opposite now 4.6% that looks like a really high

rate at least relative to my frame of reference can I replace it with 3% my advice is don't mess with it and here's what let's suppose January 1st 2022 it's 1

and a half% is the rate you replace the 1 and a half% with a 5% normalized rate you proceed to do your valuation with the 5% rate lead me through what's going to happen first your cost of equity and

cost of capital are going to be higher right you discount the cash flows back your odds are you're going to find the stock to be to be expensive the value is too low relative price you're not going

to buy the stock you know why we use the risk free rate in this process it's opportunity cost it's where you put your money if you don't want to buy a stock so in your word what are you going to do you're not going to buy the stock and

you're going to go find that normalized t-bond that gives you a 5% rate good luck with that you're living in a fantasy Universe here right this isn't an abstraction this is an actual

opportunity cost if the opportunity cost is 1 and a half% don't go looking for trouble by putting in a 5% rate and the opportunity if the if if the rate is actually 5% don't replace with a 3% you

make the opposite mistake I'm actually making your life easier because I'm saying whatever the T bond rate is at the time you do the valuation or whatever the risk rate is just let it

ride it is an opportunity cost don't normalize things don't try to clean up things don't say look I'm going to make predictions on rates people have you know those predictions are not worth the

paper they're written on when people do it but more significantly even if you can you don't want to bring it into your valuation cuz if you're right about rate going down there are far easier ways for

you to make money right go by t-bond Futures this is not the place to bring in views about interest rates so I've always pushed back against normalization

and many of you might go to work at places where people try to normalized rates and I want you to remember the argument against normalization it's not that you don't have a view on rates but this is a valuation of a company and the

risk free rate is an opportunity cost today so let's take on this fed dated challenge I told you that coming into

2021 and into 2022 wouldd come off a decade of historically low rates that decade had the lowest t-bond

rates of in the last century and of course we ask people why did that happen and especially if they watch a lot of CNBC the answer is the Fed did it right

the story I'm sure you've read right quantitative easing the FED is but let's see if in fact the FED is what kept rates slow what I've done here

the black line is actually the t- bond R and then I constructed what I call an intrinsic t-bond rate you saying what the heck is an intrinsic t- bond rate what did I say the two numbers are that

go into the interest rate inflation and a real interest rate but in the longterm real interest rates and real growth are pretty much the same number so every year I took the inflation rate that year

and the real GDP growth that year so if your inflation rate was 2% and real GDP growth is three 2 plus 3 is five I said the t- bond rate should be 5% and I graphed it up do you think the two at

least move together there's the 1970s why were rates high again it must have been the FED must have been raising rates no nothing to do with the FED inflation was

high inflation is high rais but take a look at the last decade it's a decade with historically low inflation it's the lowest inflation decade we've had in the last

century and in terms of real growth it's a decade of anemic real growth what's low plus low low there's your answer why were rates low in the last decade

because you low inflation and low real growth could the FED have an effect yes at the margin at the margin why did rates go up in 2022 oh the FED must have raised

rates no the FED didn't raise rates inflation went up rates went up the FED then chased the market raising rates to try to catch up with the market what will interest rates do in 2025 frankly I

don't care what the FED does it's what inflation will do this year and real growth will be that will determine so if you have a scenario where no you think that inflation is going to increase for

whatever reason it's a macro story it's going to show up as higher interest rates higher t- bond rate it could also be a story of real growth incre inreasing next year you know because of tax cuts that two will

cause interest rates to go up what drives rates is fundamentals and for 15 years now watch this discussion devolve into what will the FED do next

week what will it do next month and I think it's a very unhealthy discussion because it makes it sound like the FED sets rates that if they wanted to bring

rates down to 2% they could do it you know the danger of this is politicians are going to put pressure on Central Bank saying rates are too high you got to lower rates and you know

what happens the FED lowest rates in a period of high inflation you you get turkey because that's exactly what's happened in Turkey is every time

inflation goes up and there is no semblance of Independence the Turkish Central Bank there's no the FED at least has this history that from the top comes

the the the command and rates have gone up you guys have to lower your rate the only rate the FED has the central bank that has to low is like the FED funds rate and they lower the rate and we lower the rate what's the signal you're

sending to Market we don't care about inflation expected inflation goes up even more this is like you're moving in the wrong direction because you've lost

track of what it is that drives interest rates Julian your question says going predicting what will happen they're not actually no the only rate the FED actually changes the FED

funds rate that interbank borrowing rate so they can tell you they're going to raise it lower it but let's face it that's a number that none of us ever faces the rest of the rates are set by the market the fed's influence comes

from the fact that they do have access to information about both inflation and real growth you know there are 10 federal banks around the country they collect data it's amazing amount of data

not all of it is shared with the rest of the world but when the fed raises rates Here's the the the mind of the market they must be seeing something on

the ground that believe that leads them to believe that inflation will go up they're raising rates to try to bring inflation down and that's almost entirely an earned respect now that's

why this is the legacy of Paul vuler 1979 he came in and he said the only focus of a central bank is to make sure inflation doesn't everything else is secondary and for 4 years in the US

people have believed that the that the FED will put inflation front and center in terms of deciding what to do that's why I said the power of the FED comes from the perception that it has power that it is credible you take those two

away the FED stops matter in Japanese central banks nobody cares what they do right and a lot of the world central banks have zero power over markets

because nobody has any faith in in them collecting information and they have no credibility so if nothing else you get out of this class hopefully the next

time you see on CNBC some there are people who have fed Watchers their entire life is watching the FED predicting I can't think of a

more empty Life to Live than watching something that doesn't matter and forecast what it will do but this has become almost an entire exercise in itself

right yes R so outside of sending that signal from all the data that that is sinking what is the real impact of changing the repo rate on the on any

there's a very it used to be stronger 40 years ago it used to be that the FED funds rate was connected to other rates that were pegged to Prim the prim at one point in time there was this rate called

the prime rate in the US the prime rate and I remember the 80s people would talk about the prime rate the prime rate was a rate that Banks set that drove a lot of the other rates that you and I faced

on our on a credit card and stuff so in those days when the FED actually raised rates it affected the prime rate and through the prime rate it affected the rate those days are done I mean you ask people what thee you could

ask a bank what's the prime rate and they say I have no idea we've stopped tracking it because more of our rates are tied to Market interest rates your mortgage rate nothing to do with the

prime rate nothing to do with the FED funds rate it's driven almost entirely by what happened to the T bond rate you look at a graph of mortgage rates versus T bond rate they kind of move together

that's why last September when the FED cut the FED funds rate in the 3 months following mortgage rates didn't go down they went up because the t- bond rate went up

so the actual rates that are tied to the FED funds rate are very few and limited there are some business loans that might be tied to the FED funds rate but it's

probably 10% of the overall loan market and it's getting smaller so the actual control the FED has over the rates that you and I see and you and I includes businesses is very limited that's why

it's almost entirely a signaling exercise no somebody back here a question yes go ahead Jessica long B kind of TI like bad shortterm interest

rates because I feel like every time that fed makes an announcement there is like a large movement where like longterm I think you might see this is I think you know we have our priors

because we watch data we watch data selectively right we watch the DAT I think it's you know one reason I I pull back data going back to 1954 which you can from the Fred look at the FED funds

rate and the t- rate and the t- bond rate is to see if my prior are right and it turns out that the FED effect is primarily on the short end of the spectrum because fed funds is a

shortterm rate if there's any effect the t- bond rate is a life of its on it basically does whatever you know inflation and real growth are driving it to do that's why terms U curves can get

downward sloping is a Fed funds rate might affect the short-term rate but the long-term rate does whatever it long-term rates do so the connection between the three is very loose the

correlation is like 0.03 04 it's very very limited much of what happens seems to be driven by macro factors that the FED doesn't control it you know what why we look to

the FED as a set of makes us feel comfortable right we think that you know Jerome po can make our life easier right if all he has to do is lower the rat the

economy is going to it makes us feel more comfortable and More in control of what's going to happen in the future the truth is the F doesn't control the future that's why we charge a an equity

risk premium so interest rates or interest rates they're going to be driven by demand and supply and inflation ultimately and of course we talked about negative interest rates you kind of

asked answer the question asima let's stop there what exactly was quantitative easy because it must have been more because fed has always know

controlled fed funds rate what did they do in addition to that in 200 after 2008 that went into this quantitative eing just influx they bought t-on that's

all they did they went in and bought t- bonds it's a demand Supply right and you saying if they buy t- bonds could could they lower the rate and that's always been the other pathway say if they buy enough

bonds couldn't they lower the rate you know how big the Tor Market is it's like 8 trillion fed can buy 100 billion people won't even notice so the quantitative

easing at the margin Again by buying bonds it might have lowered the rate from 4.57% to 4.54% that's why I said at the Marg and all of this dancing around can lower the

rate but inflation goes to 7% you can try to buy as many bonds as you want but t- Bond rates are climbing towards 7% plus cuz and the reason is simple if I buy a bond I want to make sure inflation

is covered otherwise I'm put at a deficit even before I start so all of the quantitative easing you look through the processes were tweaking the rate not

changing it fundamentally so with negative interest rates the one question though is this is something we hadn't seen until the last decade and it freaks people out it

creates some really strange you know implications there was I think five years ago Danish homeowners were borrowing money to buy

their houses just like you know you and I might but the bank was mailing them usually when you borrow money you pay the bank every month the bank was paying

them so how can that be if you have negative mortgage rates the bank will send you a check every month you think this is amazing I want to live in this world it's kind of a

freakish World negative interest rates are never good news because it comes with deflation and negative real growth you might be getting a check from the bank but you're probably going to lose your job and your income is going to

shrink over time you got to play this process through but there's the other thing about negative interest rate that troubles people you're putting your money in the bank so let's say have

$100,000 you put your money in the bank what does the bank do it takes away ,000 you're saying why would I do that why would I just keep the money at home that's always been the push back

against negative interest rates is since you don't have to put your money in the bank and earn a negative rate why don't you just hold on to cash what's the answer to that let me ask you question how many of

you have cash in your pockets right now relatively few right maybe about $5 just in case you see a homeless person you want to give them the cash no we

don't use cash sometimes we don't even take our wallets with us because we've got our phones with us one of the consequences of being in a cashless Society is we

don't even know what to do with cash second let's suppose that wit has $10 million in cash and he decides not to put in the bank because they charge a

minus 1% interest rate so wi is going to keep $10 million of cash in his apartment where do he live with I want to pass the message on because the next

thing you have to do is hire security guards to protect you there's a consequence here of having a lot of cash so what I'm trying to say is C interest rates can get

negative and you won't hold on to cash because it's messy it's pain it's dangerous but if they become minus 3% You' probably think more seriously about

holding on to cash and hiring a security guard so interest rates can turn negative but there's kind of a floor at which people will say I'm not taking this anymore I'm just going to keep my cash as

cash so negative interest rates can happen there the the way I I think I I titled this blog was uncommon but not unnatural because people said negative

interest rates can't happen they can it's just unusual when it happens you got to think about what drives so now let's talk about Equity risk premiums I laid the foundation

right what you charge over and about what affects it everything that happens around you it's a receptical for all of your hopes and fears as an investor so right now you're looking at

the hope now is that you look at economic growth and what what you think it'll deliver and the uncertainty in economic growth inflation goes in there you worried about a crises it's in there

I won't even list them out but if you look at it everything affects it government policy affects it you saying so what this number is going to be an unstable number it's going to

change over time so any measure of an equity risk premium you come up with better be dynamic because to say that your Equity RIS hasn't changed over the

last 20 years is a conf it's a Deni you're you're in denial how can it not change so everything affects Equity risk

Brams yeah but right it is continuous risk but that means you got to estimate it input it but you got to do the work right and if you're using a historical risk premium it's not going

to move so let's set up the process with historical risk premiums this was the exercise we started with so I'm going to look backwards and I'm going to hit a historical risk premium so at the start

of every year I compute a historical risk premium on my web page why because I refuse to pay somebody for a risk premium the data is already out there I never use these historical premiums but

in case you're inclined to go with the past I have the numbers for you the historical Equity risk premiums for the

US keyword is premiums not premium is somewhere between five and 14% you saying how can you have multiple Equity risk PRS for the same Market it

depends on the slides of History you look at I've looked at three possible slices 1928 is my starting year and your 50 years and 10 years I've also looked

at the equity risk premium over t- bills as opposed to t- bonds t- bills are shortterm treasuries 3 months six and these are three Monon t- BS t- bonds are

10e t- bonds the premiums are different it even depends on how I compute my average returns see what does that even mean if I give you 100 Years of stock

returns easy way to compute an average is add the 100 numbers up divide by 100 right simple average but the problem with doing that is returns are

compounding I'll give you a very simple example to see how the compounding plays out let's say you have stocks double in your one what was the return that year if they doubled plus 100% And then they

have the year after minus 50% right so how much money do you make over the two years nothing about but if I through the magic of

arithmetic averaging you made a 25% return you just don't know it 100 - 50 is 50 / 2 arithmetic averages missed the compounding effect so what can you do you can do what's called a compounded

average jric average we look at your starting number your ending number and you look at what you make so if you start at 100 you ended at 100 I'm not going to try to fool you by saying you

made any money you did not so you got how far back do you go t- bills or t bonds arithmetical geometric averages already you can see the danger

of historical risk premiums remember we talked about bias asima let's say you are an appraiser for a private business that's

up for splitting in half because it's in the middle of a divorce you want a low number right for your client so which are these numbers you going to latch on to high highest number or lowest Equity risk

premium highest because you want the discount rate to be high so you're going to pick 134% I ask you why it came out of deodrant historical risk put that in because you can blame me that right

conversely if you want a really high number for your value you're an equity research and you want to convince me inv video cheap you can leatch on to maybe the lowest number 5.44% if I let you pick and choose

you're going to pick whatever number justifies and you be amazed and how much bias plays out in this process so if you're going to use historical risk prams I'm going to put

some guardrails on what to do first you have to go back as far in time as you can it's a pure statistical reason remember I said every estimate of an average comes with a standard error

I've actually estimated the standard error with each of these numbers and notice as I go from 100 close to 100 years to 50 to 10 the standard error is getting

larger pure pure so if you want at least a reasonable chance of getting the risk premium right better not use a 10year premium the noise in that is going to be so large that the range you get will be

useless but even with a 100 years because of data I'm ending up with the risk standard ER of 2. two roughly 2% hold on to that thought because I'm going to complete the other two things I

want you to do second this is an equity risk you're going to use in your calculations right and remember when we when we talked about valuation we talked about what the right risk- free rate to

use was did we pick tbls or t bonds and and the reason is valuation is long term so I'm going to take the tables out of the pictures this is good I'm getting rid of the numbers I can't

use so I want to go back as far as I can and I want to use t-bonds final question this number is going to go into a discount rate and what happens that discount rate I use to Discount year one

then year two it's going to compound over time I think logic alone drives you towards a geometric average so t- Bond's

longest time period geometric average 5.44% we talk about false Precision in valuation 0 44% I'm getting a little carried away with the Precision here

you know why this is false Precision that's my estimate of the equity risk beim going back close to 100 years geometric average stocks versus debonds but here's a dirty little secret I'm not

letting you in on the standard error is roughly 2.1% so if I tell you the equity risk premium is 5.4% and then I say oh by the way I forgot to tell you that the

standard ER is 2.1% do you want to quantify what that means to me if I have a 2.1% stand standard statistics what do we do to get

an estimate of the range to I think like about 4 point no let's not go that far two standard errors will get me to 95% confidence which means My Equity risk Fram for the

US with a 100 Years of History even if I assume me reversion works is somewhere between 1 and 10% right fat lot of good that does you in evaluation your equ

some you'd fire me on the spot I were estimator saying what good is that to me but that's what you're doing every time you use a historical risk premium because nobody's talking about the

standard era so as I told you at the start of this class I'm going to dig a hole for historical risk PRS and going to bury them the first problem is this this

standard noisy has and if you have trouble in the US think of how much more Troublesome this is going to be if I ask you what the equity risk premium is for Vietnam

or even much of Europe because you didn't you had that break between 1940 and 45 many European markets shut down it's not even a choice you can't even go

back there and second by using the US market I've opened myself to what's called survivorship buyers what is the most successful

Equity Market of the 20th century it was the US Equity Market I picked the equity risk premium for the most successful Market of the 20th century what am I going to do in 2024 I'm going to use it for the next

Century but in in you went back in 1901 and you had money to invest you could have chosen to invest in the US market but the US market wasn't the biggest Market in the world there it might have

been the UK Market or the Austrian Market you had no way of knowing what the best Market of the centur would be you know what that implies right if

you take an equity risk premium for the most successful Market in the world are you going to overstate the premium or understate it you're going to overstate it why because you've taken the most successful

Market you have no idea what the most successful Market will be the next Century that's a survivorship bias and if this problem is bad with the us we have all this historical data

think of how much worse it gets if I ask you to estimate an equity risk premium for a market without much history so at least I want to lay the foundations for if I want an equity risk

premium for Brazil or Vietnam or India or Indonesia or Poland given that this historical data is not even a start here you think but

India is historical data going back you take a look at the Indian Equity Market in 1968 and come back and tell me you got historical data it was a market of maybe 20 companies with very little

liquidity you don't have much historical data so you have two choices if I am a Brazilian company and I ask you to come in value first is you can ask me to come back in a 100 years so by then I'll have

enough historical data of your Market or you can try to do something today I think the ladder is a better strategy to adopt so I'm going to give you three ways in which I'm going to try to

estimate Equity risk premiums for markets outside the US in the first I start with the US Equity risk with all my qualms about what it is let's suppose

I feel reasonably okay with this number so let's work this out intuitively if my Equity risk for the US is 5.44% today that's a historical premium and I say

would you and you're investing in Brazil would you require a larger premium or a smaller premium every degree larger why because remember all those things I

talked about the drive Equity risk those are all much greater in Brazil than in the US or larger that was the easy part now the question is how much larger here's the the first and the

easiest answer it comes with limitations it's a number we've already used when we computed risk free rates for Brazil what do we do we started with the government bond rate and we

subtracted out the default spread it's number like Waldo it's going to come back again and basically if you take that number and add it to the US Equity risk

premium you have an equity risk premium for berser so if you remember the number I got was 2.83% with the the third approach let's suppose that's the approach I used on the risk free rate and that's where consistency is going to

kick in if you used a different number in the risk free rate stay with that number if that was the number I used to clean up the government bond rate I'm going to take that number and add it on

to the US premium you say where did the 4.33% come from I'll talk about that but it's a number that I think I feel more comfortable with as My Equity risk Prem for the

US I add the 2.83% to it and I get an equity risk premium for Brazil of 7.16% this is the state ofthe art if you

can call it that in how appraisers analysts and bankers estimate Equity risk premiums for other countries they take a US premium God only knows where

that comes from or you know how unstable it is and they add a default spread either using the Sovereign CDs spread or the ratings based approach or a Government Bond spread go ahead and say

I'm done what's you know clearly it's a simple approach the numbers are easy to get what what are the what are the problems this approach fundamentally or intuitively what do you think the

problem with this approaches yes or it's based on the government basically the 2.83% is what I would charge for buying a Brazilian Government Bond right the extra amount because it's

risky but I'm not buying a bond I'm buying Brazilian equities so de should help me out if uh you know and 2.83% is what I'm charging for buying a govern Bond and I'm thinking about Brazilian

equities are equities riskier than bonds generally sa they probably should be risky so I would expect the risk premium to be larger because I'm talking about equities so that was the first thing

that bothered me when I saw this approach because it was the default approach I saw it used everywhere so I'll give you the pathway I took but Goldman Sachs about 30 plus

years ago said why even look at the Government Bond there's a different way in which I can get an equity risk for braz though and here's what they did they to they comp they came up with the

historical standard backward looking but historical standard deviations in the US Equity index the S&P 500 and the baspa so let's assume the standard deviation the basa is

30% and the standard deviation in the S&P 500 is 18% Let's do an algebra problem if you're buying the 18% Market which is

the US market you're charging a 4.33% premium right but even instead you want to buy the Brazilian Market which is roughly what 1.67 times more volatile 30

over 18 1.67 * 4.33% gives me an equity risk premium for Brazil of 7.22% no when this came out people said this is great we're not looking at the

bond market we're staying with an equity but this approach has a fatal problem do you know what it is anybody want to guess what the problem is what

is it based on standard deviation of the S&P 5 standard deviation of the local Equity Index right think about what goes in the standard deviation local Equity

index obviously it's all the risk in the country but for prices to move something has to happen which is people have to trade in a market where there is zero

trading the standard deviation will Converge on zero I computed this number for the Bangladeshi Equity market last year and

it's about 5% standard deviation if I stayed with this approach I'm going to be giving the equity risk premium for banglades to be onethird of the equity

risk charging for the US which is absurd because you comparing Market with very different liquidity I've you know every year I take this approach I compute the equity

risk every Market about a third of the market look at there no way am itim investing in those markets CU what I'm getting is a reflection of the liquidity of the market not the risk of the

market so I'm going to give you my third approach this is my default approach I won't claim that it's the best approach but it's an approach where I tried to negotiate what I can in terms of

compromises I start with the 4.33% just like it in the first approach but instead of adding the 2.83% to it I scale up the 2.83% for how much riskier

stocks are relative to bonds within the Brazilian Market you say how do you do with the liqu liquidity issue if there's light liquidity in one market there's probably light liquidity in the other Market the Bangladeshi Equity Market has

very little liquidity but so is the Bangladeshi Government Bond at least I'm comparing Apples to Apples that

ratio for Brazil was about 1.5 the Brazilian Equity index was 1.5 times more B than the Brazilian government Bond yeah simple so for standard

deviation how far are you going it doesn't matter use the same for both right it that's a it's a ratio that matters right so unless you believe the ratio is going to be off if you use 6

months use two years then it's basically a sense of how much riskier are equities and bonds within this Market that number gives me 8.58% very different numbers that's a number you'd see in my

valuation and if you use one of the other two approaches I'm not going to say you're wrong it's just a different it's not going to make or break your valuation but I think you need to pick an approach that works across all

countries not one that just works on this country because you might have to do this on seven different countries for your company and you got to make sure it's so

this is an exercise at the start of every year that I go through I yeah go ahead Margaret does this require basically like going back to the country I have to issue a

us-based it doesn't have to be it can be a local B it has to be traded there has to be government Wars traded and there in lies a promt that's available for only what what 37 countries that he saw you saying what do you do with the rest

I'll talk about what I end up doing in practice because it's very messy staying with local government bonds trying to get this for every country so started 2025 like I have I think it started this

for the first time in 1992 so it's kind of a 33-year old database most widely the most downloaded data set on my website I want to computer Equity screams my country I start with the US

premium and I as I said I'll come back and back into the 4.33% that's my starting point then I look up The Sovereign local currency rating remember I said there are two ratings for every

country local currency and foreign currency I look up the local currency rating your country if you're AAA rated I classify you as a mature market

and I give you exactly the same Equity risk premium as the US why because if you have 10 mature markets with different Equity risk premiums money is going to flow across them and even out

the premiums so every AAA rated country is going to get the same premi us so let's name some AAA rated countries let's see how many you can come up with let's start with Europe there are quite a

few all of you can go so don't even look to the South there's nothing there right so start Germany work upwards so you got Germany

Netherlands Switzerland Sweden they all get 4.33% prems let's move over to Asia there's only one

country in Asia with a AAA rating which is Singapore right go go to to Australia New Zealand both AAA rated come to North

America you got Canada you got the us both AAA rated us less AAA rated than Canada because you got three different ratings agencies and only Moody still

gives a AAA rating but I'll hold on to that for the moment and then you go to Latin America don't even look for Ratings than a in it and it's going to

be be something know basically good I think Chile might be the only one that's tipped over into the a scale but not no AAA rating countries for those countries which don't have AAA ratings here's what

I do I take the rating and I come up with a default spread if that sounds familiar that's how I got the 2.83% for Brazil right that lookup table I look at the default spread when I first started

doing this I then would go look for looking for a Government Bond and Equity index in each country and as Margaret pointed out two problems one is a lot of countries don't have government bonds and in the countries that do have

government bonds many are not traded so I started cheating about 20 years ago and I haven't stopped instead of looking up each country I look up two indices one is an S&P index of emerging market

equities it's actually a widely invested in index you can get the price every day so you go to the S&P website you can download the data for The Last 5 Years actually download for the last two

years and then I found and this was pure luck I found an ETF that invests only in Emerging Market government bonds which is St it's I can get the price and I looked up the standard

deviation the ETF and you can see where I went next I took the the Emerging Market Equity index divided by the Emerging Market Bond index and I came up with 1.35 what does that tell me based

on those numbers I'm going to take the default spread you have as a company let's say it's 2% multiply by 1.35 it makes me 2.7% add it on to the

4.33% I've got an equity risk premium for your country question but isn't it a stretch Dr that there are lots of

stretches here right but what's so what what is the part that you would unstretch no no tell me so what's the part that's the stret the

1.35 would be same so what's your alternative to that okay so I think that when you make stretches it's because there's no easy

answer right of course I agree right but if you decide and there are people say well I'm not use the 1.35 at all because it's too much of a stretch and you know what they end up doing using just the

default spread is one any better than 1.35 isn't that a stretch sometimes people think if you don't make an assumption you say but you always have to make an assumption when you use one

as your ratio you are making an assumption I think I'm on safeer ground assuming Equity is riskier than government bonds so this is a number I wrestle with every single year I've

changed the way I do this because the data has improved but it's a work in progress so here's what the world look like to me at the start of 2025 pick

your favorite part of the world or your least favorite part and let's go on a trip I'm sorry you don't have your name play what's your name

again Y is a Brazilian right so let's go through Latin America exciting place this is like a jungle ride and on Disney

there's what Latin America looks like there is a AAA rated country in the safest market so basically the way to read there's the rating which gives me

the the country risk premium so the country risk premium is the default spread times 1.35 and added to the 4.33% gives me the equity risk P safest Market

if you include this is Chile right historically that's been true the and why is the aqu SP so low because the rating is high there's no intellectual Firepower here right basically it's

driven by the rate the riskiest Market probably no surprises yeah you got a tie between Venezuela is probably at at the very PE 28 that's your risk premium think of what happens to your discount rates even if you do things in dollar

terms 27.6% and you got Argentina you know har has a lot of work to do and basically you can see the variations across that

Amica and he say what is this number for all of Latin America it's a weighted average weighted by what by the GD D pce of the countries Brazil and Argentina obviously count or Brazil at least

counts for a lot more than everybody else because it's a larger and I do this for every part of the world but let me complete the process you saying what is that black box at the

top take a look at the countries and you're very quickly going to see what they have in common Guinea BAU Guyana Haiti Iran North

Korea Liberia Libya Madagascar Malawi Myanmar Russia Sierra Leon these are called Frontier markets what do they share in common they don't have a rating why do

they not have a rating let's play it out let's suppose you take a job at Moody's the first day at work your boss calls you and says I'm going to give you a country to rate you're excited first day

you give where am I going you're hoping for Switzerland and they say you're going to North Korea you probably quit on the spot right there's a reason they don't have a

rating the rating ages throw up their hands Russia used to be in the rated column it's gone because starting in 2022 the ratings agencies have just thrown up their hands and for the longest

time I did not compute risk premiums for those countries and my defense was there's no rating but starting about 10 years ago I said that's not fair you might have business in

Syria or in North Korea I don't know what kind of business it is but some business and he need an equity risk PR so here's the process by which I estimate Equity risk BRS for those countries

there are these services that measure country risk scores The Economist does it I use a service called political risk services not because it's better or worse but because I've used it for a long time I'm comfortable with how they

do the numbers their scores go from low to high low being the riskiest countries High being safe last year for instance the highest core country the the safest country was

Switzerland the riskiest was a tie between Sudan and South Sudan and somewhere over there I found and they have political risk scores for North Korea and Syria

and countries which don't have a raid so I look up that country risk score and they talked about stretches I'm going to do a real stretch say okay I know the

country risk score for Libya let's not take a different Sierra Leon is 59.5 I go looking for countries which scores between 55 and

60 I found five three of those countries had ratings and had estimated an equity risk premium for them so complete the process what do you think I

did I took the average across to three I attached liya and Si I'm done is it a stretch absolutely but if you can find a better way of estimating Equity risk

rooms in North Korea I'd love to your ideas here but I have a number no matter where you operate in the world I can say this is what the equity risk premum looks

like I told you this the most widely downloaded data set on my it gets used in the strangest places sometimes I can track where

people are coming onto my way you know one month Lithuania usually the top is you know nice thing about having people in India follow you is that already

pushes the numbers of indias at the top but then you the English speaking us UK Australia but Lithuania was on top of the list I said what the hell is happening in Lithuania why they looking

up my risk premiums and it turned out that for a period privatizations in Lithuania you were required to use My Equity I have no control over this [Music]

process so this gets used in strange places in bad ways I claim no responsibility for it but at least now if you run into an equity risk from

claiming to come from my web page people have visions of me doing country risk analysis all year I have zero interest in doing country risk analysis I have

zero skills in that you know why and sometimes people get pissed off at me because I gave their country a really high Equity risk premium people argue with me I'm we're safer than this

neighboring country how come I RIS I am not the one who's doing this Moody is doing this to you because I'm starting with your rating so if you're from turkey and you don't like the fact that

your equ risk is higher than Greece I'm not the one who signed it basically a function of ratings and Greece used to be a lot worse than you are right now 10 years

ago and they've moved in the right direction because the ratings have improved so if you get a chance take a look at the Excel spreadsheet that contains this data because it contains all of the raw

pieces that go in and it gives you options you don't like ratings I give you Sovereign CDs sprads as an alternative but next session we're going to talk about what to do with these Equity risk means and value individual

companies here