Calculating a “True” Risk-Free Rate: India as an Example

June 08, 2025

Calculating a “True” Risk-Free Rate: India as an Example

Estimating a Risk-Free Rate: A Case Study of India:

Introduction:

In the realm of corporate finance and valuation, the risk-free rate is a critical benchmark used to determine both the cost of equity and the overall cost of capital ( WACC ), within a specific currency. Traditionally, practitioners have relied on sovereign bonds, particularly those issued in local currency by financially stable governments, as proxies for risk-free assets, under the assumption that these instruments carry negligible default risk. yet, historical experience reveals that sovereign defaults and restructurings, even on local-currency obligations, are not unheard of. As a result, the yields on such bonds often reflect an embedded default premium, challenging the notion of a truly " risk-free " benchmark.

Aswath Damodaran has popularized a straightforward yet powerful adjustment: strip out the sovereign default spread from the government bond yield to arrive at a purer “risk-free” rate. This blog post will explain:

Why this adjustment is necessary, the purpose and need for isolating the true risk-free rate.
How to perform the adjustment, an up-to-date, step-by-step walkthrough following Damodaran’s methodology, using India as a concrete example.

1) Why Subtract a Default Spread? The Purpose and Need:

In valuation methodologies, ranging from basic dividend discount frameworks to comprehensive discounted cash flows, (DCF) analyses, it's essential to apply a discount rate that reflects a true zero-default risk. Incorporating any degree of default risk into the so-called "risk-free" benchmark can distort the outcome, as it inflates discount rates, suppresses asset valuations, and leads to inaccurate estimations of the cost of capital.

Governments Can Default on Local-Currency Debt:

Traditionally, advanced economies such as the U.S are viewed as having negligible default risk on local-currency debt.( Although the United States has recently lost its final top-tier credit rating following Moody’s downgrade, the last of the three major credit agencies to take such action, it remains a key player in global finance)

In contrast, emerging and developing nations may at times opt to default rather than endure extreme inflation or fiscal tightening, As a result, their local-currency bond Yield often carry a default premium above the risk-free benchmark.

Implications for Valuation and Capital Budgeting:

If you assume the raw 10-year bond yield is risk-free, you are implicitly baking in some probability of default. That makes your discount rate too high and valuation too conservative. Instead, by subtracting the default spread, you reclaim a cleaner, lower “risk-free” number that better reflects a zero-default‐risk investment.

A Two-Pronged Approach to Estimating Default Spreads

1) Ratings-Based Lookup:

Use a country’s local‐currency sovereign rating (e.g., Moody’s, S&P, or Fitch), then refer to a Damodaran‐published table mapping each rating to a typical default spread.

2)CDS-Based Market Measure:

If credit default swap (CDS) data are available, the quoted CDS spread (in basis points) can serve as a direct market estimate of default risk

2. Step-by-Step Example: India’s Local-Currency Risk-Free Rate

Below is a detailed walkthrough, for computing India’s 10-year “risk-free rate” in INR as of June 2025. Wherever possible, we cite the latest data and sources.

Step 1: Identify the 10-Year Government Bond Yield:

What to find: The yield on the benchmark 10-year Indian government security (G-Sec) in local currency (INR).

(You can do a quick google search to find out the information.)

Source: Trading Economics / Macro Micro data indicates that on June 6, 2025, India’s 10-year G-Sec yield was 6.23%

Step 2: Determine India’s Sovereign Credit Rating (Local Currency)

What to find:

The current local-currency sovereign rating from Moody’s (or Moody’s equivalent of an S&P/Fitch rating).

Source:

As of May 2024 (and unchanged into 2025), Moody’s rates India at Baa3 (Stable); likewise, S&P and Fitch both rate India at BBB– (Positive/Stable).

Why this matters: Damodaran’s lookup table maps each rating to a “default spread” estimate. For India’s Baa3 rating, we will extract that default spread in the next step.

Step 3: Fetch India’s Default Spread from Damodaran’s Table

What to find:
The “default spread” corresponding to Moody’s Baa3 rating in Damodaran’s Country Default Spreads and Risk Premiums table (January 9, 2025 update).

Source: Damodaran’s data file indicates that for India (Baa3), the default spread is 2.18%.

Clarification: Damodaran computes these spreads by averaging CDS spread data for each rating bucket and then interpolating when direct CDS quotes are unavailable.

OR, You could also get it from AI, like Chatgpt. all you need to do is, put this prompt on an AI tool like chatgpt,

"As per Aswath Damodaran recent data, info what is the default spread for India based on India's recent sovereign rating?"

Step 4: Compute the “True” Risk-Free Rate (INR)

Risk-Free Rate (INR) = 10-Year Yield − Default Spread

= 6.21% − 2.18%

= 4.03%

Result: India’s true risk-free rate in INR ≈ 4.03% as of early June 2025.

Interpretation: By stripping out the 2.18% default premium, we arrive at a cleaner “risk-free” benchmark for discounting rupee cash flows.

3. Putting the Risk-Free Rate to Use

1) Cost Of Equity in INR,

When valuing an Indian company in rupees, compute:

Note:

India's Equity Risk Premium (ERP) can typically be estimated using data from sources such as

Damodaran's country Default spreads and Risk Premiums, often cited at approximately 7.26% as

of January 2025, or by adjusting historical ERP estimates to reflect current market Volatility

So, As of Jan 2025, India's ERP is 7.26%, With Adjusted Risk-Free Rate of 4.03%, and if we assume a company to have a Beta of 1.75, then for that company, the Cost of equity would be,

(4.03%+7.26%) x 1.75 = 0.197575 * 100

Cost Of Equity = 19.75%

2) Cost of Debt in INR

3) Country Risk Premium (for USD-Based Valuations)

When valuing an Indian subsidiary in U.S dollars, it's common practice, such as in Damodaran approach, to incorporate a country risk premium (CRP), into the U.S risk-free rate, rather than estimating a risk-free rate denominated in Indian Rupees, (INR). This Premium is calculated to account for the additional risk associated with the country's specific economic and political environment.

Formula:

Country Risk Premium = Default Spread (2.18%) × (σ_equity IN INR / σ_equity IN USA)

Then add the resulting CRP to the U.S T-Bond Yield to get a USD discount rate.

4. Where to Find the Data (Quick Reference)

10-Year India G-Sec Yield (INR)

; TradingEconomics / MacroMicro

5. Key Takeaways

Why It Matters:

Local-currency bond yields in emerging markets often reflect sovereign default risk. Treating these yields as risk-free can distort valuations by overstating risk and discounting future cash flows too heavily.

Damodaran's Fix:

To estimate a accurate risk-free rate in Indian rupees, Damodaran suggests adjusting the 10-Year government securities yield by removing the country's default spread. For India, this involves subtracting a default spread of 2.18% from the 10- Year Yield of 6.21%, thus resulting in an implied INR risk-free rate of approx. 4.03%

Broader Implications:

Adjusting to a corrected risk-free rate enhances the accuracy of all subsequent valuation metrics, such as the cost of equity, cost of debt, WACC & country risk premium (CRP), by better reflecting local sovereign risk.

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