In applying the CAPM in estimating the cost of capital in an emerging market,explain the three problems in estimating an appropriate risk-free rate and the recommended solution.

Question

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The Answer is In emerging markets,the risk-free rate is harder to estimate from government bonds than in developed markets.Three main problems arise.First,most of the government debt in emerging markets is not risk free,and often the debt is below investment grade.Second,the long-term government bonds do not actively trade and are relatively illiquid.Finally,the long-term debt that is traded is often in U.S.dollars,a European currency,or the Japanese yen,so it is not appropriate for discounting local nominal cash flows.
The solution is to start with a risk-free rate based on the 10-year U.S.government bond yield and then add to this the projected difference over time between U.S.and local inflation.The result is an estimate of the nominal risk-free rate in local currency.

In Applying the CAPM in Estimating the Cost of Capital