The rate of interest on the risk-free security (the risk-free rate) is one of
the building blocks valuation professionals use in developing the cost of equity
capital. Selection of the risk-free rate allows one to "scale" the cost of
equity capital for the expected inflationary environment. But during late 2008
and early 2009 and again during the summer of 2010 risk-free rates were
abnormally low and inconsistent with their theoretical formulation due to a
"flight to quality."
Another key building block is the equity risk premium (ERP). Choice of the
appropriate ERP as of the valuation date is one of the most important decisions
the analyst must make in developing a discount rate. Any estimate of the ERP
must be made in relation to a risk-free security. That is, the expected return
on a fully diversified portfolio of equity securities must be measured in its
relationship to the rate of return expected on a risk-free security.
The Great Recession of 2008-2010 has necessitated we reconsider many methods
of analysis we took for granted during periods of stability. 1 The choice of a
risk-free rate and estimate of ERP are just other examples of the difficulty in
pricing risk during these uncertain economic times.
1 The recession technically began in December 2007 and lasted 18 months to
June 2009, the longest since the 1929 crisis. But in many persons' opinion the
recession continued, hence why this author is using the term the Great Recession
These sessions are available ONLINE ONLY. This PDF
and MP3 downloads will be available for 3 days
after the purchase date. Please download