Estimating Zim’s risk-free rate

This risk-free rate is very important because it is used as the base for calculating the expected return for any investment.

The concept of a risk-free rate is a very fundamental idea in the field of finance and the bedrock of most asset valuation techniques. It is the return one gets on a risk-free investment and a risk-free investment is where the expected return is the same as the actual return, meaning there is no variation of returns and there is certainty of returns.

Essentially risk-free rate of return is the reward that surplus economic units demand for deferring consumption of their capital, assuming that there is no credit risk whatsoever. If one chooses not to consume a dollar today and invest it in a risk-free asset, whatever return she gets is the risk-free rate and is the minimum possible rate of return to lure her to postpone consumption for that particular period.

This risk-free rate is very important because it is used as the base for calculating the expected return for any investment. If you talk to equity research analysts, they will tell you of the famous Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT) that utilises this risk-free rate in estimating the expected rate of return.

Option pricing would be difficult without this rate, and one might not know this, but this risk-free also influences even the interest rates that are charged by banks on your loan or overdraft.

Put into everyday life, this rate of return is like that important relative in a family who you probably don’t know exists but is very critical for the smooth going of all family affairs.

Well, then you might be asking if there is any investment where one is certain of a return and there is no variation whatsoever.

Yes, and in the world of finance, it is generally acceptable to assume that certain governments cannot default since they can print money to cover their obligations, at least if the obligation is in their local currency that they have control over.

If you come from where I come from, perhaps you are already itching to argue that well that might not be always true, but that’s a debate for another day altogether.

These governments are also rated, based on several factors including the past performance of their issued debts and a AAA-rated government-issued security might be treated as a risk-free rate.

The risk-free rate is also time-sensitive, and the tenure of the government security needs to match the duration that the risk-free rate is applied to avoid reinvestment risk.

If for example one needs an annual risk-free rate to discount five years of cashflow but uses a 91-day government treasury bill, there will be a mismatch even if the government is AAA-rated.

Not all governments are AAA rated and other governments default on their obligations.

Default generally refers to failure, including delay to meet the financial obligations and a more sophisticated analysis will also include things like change in currency as default.

To explain the point, Zimbabwe officially de-dollarised in 2019 and made a landmark ruling that all prior obligations were converted at par to a new currency when the alternative exchange rates had moved from parity.

This means that even if an investor received all their payments timeously, the change in currency affected the real return and there was a variance between the expected and actual return and the point to take home is that governments can and do default.

This makes it very difficult to estimate the risk-free rate of Zimbabwe, but we will continue to explore other accepted ways to estimate this number.

The first way to estimate the risk-free rate in Zimbabwe would be to start with the cost of debt and then remove the country's default spread. The average cost of debt that I have gathered is around 16% per annum and the default spread according to Damodaran is at 9.81% leaving the risk-free rate just over 6%.

Is 6% a fair representation of a risk-free rate of return in Zimbabwe?

Let us explore something else to see what we can get.

I know this can become very controversial but in the 2024 national budget, auction funds that had not been paid were exchanged for non-negotiable certificates of deposit (NNCD).

NNCD does not normally fall under the usual definition of a Treasury bill or bond but because of scarce information, one might assume the rate of the NNCD to be representative of what the treasury would be willing to pay for its instruments.

These NNCDs are fetching an interest rate of 7.5% per year, which is not far off from the one we extrapolated from removing the default spread from the cost of debt.

One also has to remember that these NNCDs are in ZiG and make some adjustments.

The average commercial bank deposit rates also don’t qualify as risk-free rates under any normal circumstances, but in difficult circumstances like the ones we are in, one might want to have a look at what these rates look like.

According to RBZ, as of the end of May, these rates ranged between 4 – 6%, which is also not far off what we have already considered as proxies to the rate, however, one needs to be aware of the risks associated with these rates.

In conclusion, coming up with the risk-free rate in Zimbabwe is not an easy task due to mainly the economic environment.

Nevertheless, the rate remains an important one and the task is upon us, the financial analysts to try and estimate. I have estimated that the risk-free rate in Zimbabwe could be anything between 6 – 8%.

  • Hozheri is an investment analyst with an interest in sharing opinions on capital markets performance, the economy and international trade, among other areas. He holds a B. Com in Finance and is progressing well with the CFA programme. — 0784 707 653 and Rufaro Hozheri is his username for all social media platforms.


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