To paraphrase an important aspect of Finance 101, "the way to calculate the required return of a risky asset is to add a margin of risk to the risk-free rate".
For example, the risk-free rate on a longer-term investment in New Zealand is the yield on 2021 Government Bonds (around about 5.5 per cent a year) and, via various calculations, you might determine that another 3 per cent a year was appropriate for risk.
So your required return on the asset you were looking at might be 8.5 per cent a year.
If it returns more than 8.5 per cent a year you go ahead with the project and if doesn't you don't. No problems there.
But ever since this theory was devised the risk-free rate was considered to be the yield on short-term government bonds if you are investing for the short term or longer-term government bonds if you are investing for the long term.
That methodology worked well up until just recently when some of the world's risk-free rates suddenly don't look so risk-free any more.
Investment analysts in Greece, Portugal or Spain trying to determine what rate of return is appropriate to benchmark the investment metrics of a new power plant, factory or building may well be giving the issue a bit more thought than usual.
Over in Athens, where they are rioting over contentious issues like living within their means and increasing the retirement age from an average of 53 years, the risk-free rate has increased markedly of late.
For example, investors were happy lending the Greek government five-year money at about 3-4 per cent a year ago. But today, after the rioting and the anti-creditor rhetoric, the bond vigilantes are back in charge and were demanding a yield of more than 10 per cent before the bailout by the European Union.
That not only puts the Greek Government's finances under pressure, it is a good bet that not too many projects are going to be sufficiently profitable to get the nod from directors when the required rate of return is around 15 per cent - that is, 10.5 per cent plus a 4 per cent margin for risk.
The question before the panel, therefore, is how long can government bond yields last as a proxy for the risk-free rate in countries whose government debt markets are in crisis?
This question of "how do we appropriately benchmark risk when the risk-free rate is under the biggest attack that it has been in our lifetime" has occupied the thoughts of Jim Reid, a strategist at Deutsche Bank in London.
He looked at the question in the bank's annual default study and figured there would be debate on the topic for at least the next five years.
Earlier this month Andrew Smithers of the economic consulting firm Smithers and Co in London produced an interesting report looking at the limits of government debt - that is, how much is too much? It is an interesting question because the co-ordinated government response to the stock market collapse of 2008 involved transferring much of the distressed debt held by banks and other financial institutions to the public sector - taxpayers, in other words. It's not a great deal for taxpayers, it must be said.
Our own government has done this on a much smaller scale, thank goodness, with the finance companies. Whether it should have done so is debatable but most other Western countries have done it in a much bigger way.
According to Smithers, this strategy is based on a belief that the surge of bankruptcies which followed the stock market crash of 1929 was the major cause of the depression in the 1930s. The tactics of the central banks this time around has been to avoid that mistake.
If anything looked like failing, the government started bailing. But as Smithers explains, governments can't keep running up more and more debt forever.
He warns that while this strategy has worked in the short term, the net result has been to increase the likelihood of an even more serious financial catastrophe sometime in the future.
Smithers writes: "History suggests that a clear danger point is reached with government debt when the cost of paying interest on the debt is as great as the likely growth of the economy.
"If an economy has to pay 3 per cent real interest rates and has net debt equal to 100 per cent of its GDP, then if the economy grows at less than 3 per cent the country has to run a balanced budget in order to prevent the debt/GDP ratio from increasing."
This view is rehearsed by Professors Rogoff and Reinhart in their book This time is different in which they write, quite prophetically, that history records that banking crises were "inevitably followed by sovereign debt crisis".
It is anyone's guess where the European crisis will stop but New Zealanders can take some comfort that our government debt as a percentage of GDP is nowhere near as bad as it is in most of the developed world.
What's more the Budget looks like a major step in the right direction. Accordingly it was greeted enthusiastically by financial markets and NZ 10-year government bond yields have fallen from 5.91 per cent to 5.57 per cent in the month.
This is a big deal. A similar fall in interest rates has happened in Australia as global investors compare Australasian government debt-paying capacity with that of other countries. Our position, with government debt as a percentage of GDP forecast to peak at 28 per cent in 2015, looks good compared to Europe at an average of 85 per cent and the G7 countries at 118 per cent.
Greece is forecast to hit 145 per cent.
The numbers for Greece, Spain and Ireland suggest that some sort of default is inevitable. The other variable that markets look at when determining creditworthiness of governments is the capacity to pay the debt - higher-growth countries are preferred as higher growth equals higher taxation.
Unfortunately high government debt is associated with lower rates of growth and, in Greece, Spain and Ireland, their real interest costs are higher than their projected growth rates. These issues are the reasons for the recent weakness in stock markets.
Just when things were starting to look safe again the European government bond market has well and truly spoiled the party.
This reminds me of a quote by one of President Bill Clinton's political advisers: "I used to think that if there was reincarnation I would want to come back as the President or the Pope. But now I would like to come back as the bond market - you can intimidate everybody."
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request at no charge.
<i>Brent Sheather</i>: Risk-free rates a bit of a gamble
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