Home » Uncategorized » Hull et. al. Risk Premium Paper

Hull et. al. Risk Premium Paper

Hull, Predescu, and White, Bond Prices, Default Probabilities and Risk Premiums, here.

A feature of credit markets is the large difference between probabilities of default calculated from historical data and probabilities of default implied from bond prices (or from credit default swaps). Consider, for example, a seven-year A-rated bond. As we will see the average probability of default backed out from the bond’s price is almost ten times as great as that calculated from historical data.

Damodaran, Stern, NYU, Dec. 2008, What is the riskfree rate? A Search for the Basic Building Block, here.

The risk free rate is the starting point for all expected return models. For an investment to be risk free, it has to meet two conditions. The first is that there can be no risk of default associated with its cash flows. The second is that there can be no reinvestment risk in the investment. Using these criteria, the appropriate risk free rate to use to obtain expected returns should be a default-free (government) zero coupon rate that is matched up to when the cash flow or flows that are being discounted occur. In practice, however, it is usually appropriate to match up the duration of the risk free asset to the duration of the cash flows being analyzed. In corporate finance and valuation, this will lead us towards long-term government bond rates as risk free rates.
In this paper, we considered three problem scenarios. The first is when there are no long- term, traded government bonds in a specific currency. We suggested either doing the valuation in a different currency or estimating the riskfree rate from forward markets or fundamentals. The second is when the long-term government bond rate has potential default risk embedded in it, in which case we argued that the riskfree rate in that currency has to be net of the default spread. The third is when the current long term riskfree rate seems too low or high, relative to historic norms. Without passing judgments on the efficacy of this view, we noted that it is better to separate our views about interest rates from our assessment of companies.

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