What happens to the risk-free rate if (when) U.S. debt is downgraded?

BVWireIssue #107-1
August 3, 2011

A BVWire reader recently asked us this question, and we turned to Roger Grabowski (Duff & Phelps) for one answer:

During these episodes of flight to quality [securities and assets], one needs to reevaluate simply using the quoted risk-free rate as the basic building block in estimating the cost of equity capital. One needs to identify whether the flight to quality has influenced the market interest rate. On a monthly basis, analysts could follow changes in the market interest rates relative to a rolling average of prior months interest rates and various economic indicators, for example, the flow of funds, the implied volatility derived from options, changes in estimates of inflation, etc. Once analysts suspect that the market interest rates are abnormally low, they could use a build-up approach to estimate a normalized risk-free rate looking at the real rate of interest and inflation estimates.

Look for Grabowski’s detailed response in the September Business Valuation Update.

Please let us know if you have any comments about this article or enhancements you would like to see.