finance

FIN630 HW3:

Risk-Free Rate and Market Risk Premium

To complete this assignment, you must

1. Estimate the risk-free rate in

a. US dollars,

b. Euros and

c. Mexican Pesos.

If there is no risk-free asset in the currency, you must estimate the risk-free rate in three different ways.

2. Estimate the market risk premium for investments in

a. The US,

b. Germany, and

c. Mexico.

Note: The data here is from September 13, 2018

1. Estimate the 10-year risk-free rate in U.S. Dollars, in Euros, and in Mexican Pesos.

I have attached some Bloomberg screen shots and other data to help you. Please refer to the Moody’s website (link on Blackboard under Data) for bond ratings. If there are no Aaa rated bonds available in a currency, estimate the risk-free rate in three different ways:

1. Using foreign and sovereign debt yields

2. Using CDS spreads

3. Using an estimate based on ratings.

In other words, I am looking for 1 number for Dollars, 1 number for Euros, and 3 numbers for Pesos. Be clear where you are getting the numbers you use and the calculations you do to get your final answers.

2. Then estimate the market risk premium for an investment in the U.S., in Germany, and in Mexico.

To help with this, I have attached estimates of the volatility of the stock and bond markets in Mexico. The current implied market risk premium (based on the S&P500) is 5.04%.

Here is some World Bond Market data:

Unless otherwise indicated (for Brazil, Argentina, and Mexico) these bonds are issued in the local currency.

Here is some info on Peso-denominated Mexican bonds. You can assume that dollar-denominated and peso-denominated Mexican bonds have the same rating.

Here is some 10-year Credit Default Swap (CDS) Market data:

Note: The “Spread” column gives the current price in basis points for the CDS. A basis point is 1/100 of a percent.

Here is a table of approximate default spreads by rating.

Rating	Default spread in basis points
Aaa	0
Aa1	41
Aa2	51
Aa3	62
A1	72
A2	87
A3	123
Baa1	164
Baa2	195
Baa3	226
Ba1	256
Ba2	308
Ba3	369
B1	462
B2	564
B3	667
Caa1	769
Caa2	923
Caa3	1025
Ca	1230

Assume that the Mexican equity market has a standard deviation of 32% and the Mexican bond market has a standard deviation of 20%.