Talk:Risk-free rate

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Given the vital application in investment portfolio management and derivative pricing theory, I think that the risk free rate deserves a much richer discussion in Wikipedia than it seems to have received so far - if anyone wants to engage on more of a theoretical level with this one please do let me know. Zoe Lindesay (talk) 17:12, 4 April 2012 (UTC)

Also I'm unsure why this is categorised as of 'mid importance' when it is a key parameter for much of financial economic theory and yet much of the article is about how there is no clear definition of the term or universally agreed approach to coming up with a proxy for the risk free rate.

Short-dated rate

There is a bit of an issue here with the requirement of using a short-dated rate. I do agree that in many cases it is true, on the other hand in the Black-Scholes formula the rate used is the zero-coupon rate corresponding to the maturity of the (European) option.

For simplicity I'd suggest to shorten the article and not make any reference to short-dated - any views?

SKL

Citations on origins needed

Why no citations of the origin of the concept? Jim Bowery 02:53, 10 August 2005 (UTC)

I would think that inflation would be considered a risk. Maybe it should be added? --Rotten 21:44, 11 May 2006 (UTC)

German bills VS Euribor indicators

As far as I know the trend has changed in European markets, so the reference moved to Euribor rates, from 3 to 6 months. I am unsure if German Bills are still used, so the reference will be kept.

US Treasury bills VS USD LIBOR indicators

And as far as I know most banks in the USA use LIBOR curves, which include a euro-dollar futures section, as well as swap rates, as their risk free curves. The USD LIBOR curve is not as highly credit ranked as the US Government. Liquidity also plays a role--the euro-dollar futures are much more liquid than the published LIbor resets. —Preceding unsigned comment added by Eduardoherranz (talk • contribs) 15:25, 27 April 2009 (UTC)

Russia defaulted on its domestic short-term government bond

can this be included? —Preceding unsigned comment added by 82.11.236.219 (talk) 06:12, 10 January 2008 (UTC)

I think it should be included, also other short term government debts for major currencies should be mentioned, i.e. for UK, Japan and the Swiss Franc. I'm not very accustomed to using wikipedia to do these things, so hence only the suggestion for now.

Academics Say Swaps Closer to the RFR

Choudhry (2005) states: “Government bond markets (…) have experienced low liquidity and supply constraints, leading to inverted curves, causing some commentators to suggest that the government yields have traded below the true risk-free level.” “[The] government curve may on occasion be overvalued, whereas the swap curve can be regarded as lying at fair value.” “[The] only plausible alternative to the government yield curve in the euro and sterling market appears to be the interest rate swap.” “The swap market, however, is now very large and liquid, and does not suffer from illiquidity, even out to long-dated maturities. There are also no supply constraints in the swap market, unlike for (say) long-dated gilts or Treasuries.”

Feldhutter and Lando (2007) state: “…the riskless rate is better proxied by the swap rate than the Treasury rate for all maturities.” Hull, Predescu, and White (2004) estimate a risk-free rate for the US market using swap rates and CDS premiums The 5Y Treasury yield lies 60 bps below the ‘true’ risk-free rate The 5Y ‘true’ risk-free rate is on average around 10 bps less than the swap rate —Preceding unsigned comment added by 66.28.42.142 (talk) 15:44, 27 April 2009 (UTC)

Dubious

the risk-free interest rate, therefore, reflects the likelihood that the government will print money to pay its debts,

Doesn't it at least partially (or mostly) reflect the time preference of money? Derobert (talk) 17:06, 21 September 2009 (UTC)

I don't think that is really the case. The time preference of money, as far as investing goes, centers on how to increase its purchasing power. In an inflationary environment, a set payment is better now, but in a deflationary environment a set payment would be better in a year. I believe that the statement above would be correct to a partial degree. The risk free rate is simply the portion of a return that is profit, and the marginal return has an inflationary component based into it. This inflationary premium will increase to reflect the likelihood of a government debasing its currency by printing increasing supply. The "risk free" rate would then be what a person is willing to take in order to loan his money with 100% faith of getting back the par. This makes sense when looking at T-bills because inflationary fears are marginalized over such a short time period. —Preceding unsigned comment added by Cccates (talk • contribs) 01:20, 17 October 2009 (UTC)

The risk-free rate does not reflect the likelihood that the government will devalue money to pay debts. One component of the risk-free rate is what is known as purchasing power risk, or "inflation risk," which is the risk that, for whatever reason, your money at the end of the term won't be able to purchase as much as it would at the start of the term. This could happen due to monetary expansion, yes, but it could also happen for other reasons - for example a supply shock in a key factor of production.

Besides purchasing power risk, the risk-free rate also includes interest rate risk, which is the risk that after purchasing a security, prevailing interest rates rise, meaning that 1) you are no longer receiving the best possible return among otherwise equal assets, and 2) the market value of your security will fall since it would have to sell at a discount to yield the same effective rate of return for a current investor.

Intertwined with purchasing power risk and interest rate risk is the liquidity risk, which is the risk that you will need the funds invested in the asset immediately, and you will have to incur a monetary loss in order to convert that asset into transactionable money. I say it's intertwined because if interest rates rise, you'll have to sell your asset at a discount, so the loss you incur is both the result of liquidity risk and interest rate risk. In general, government securities carry very little liquidity risk due to the extremely broad and active secondary market, so this probably is not technically a component of the risk-free rate.

The point is, the risk-free rate of return is the rate of return, over a given time period, that an investor will demand in the absence of credit risk in the case of debt instruments and market risk in the event of equity instruments. It's a baseline against which one can calculate a required rate of return for an investment that does have risk, using formulas such as the Capital asset pricing model.

Hope that clears things up. AvoidingRealWork (talk) 17:45, 29 March 2010 (UTC)AvoidingRealWork

Actually, you can run out of fiat currency

I just recently read that, late in the history of the Mobutu regime in Zaire (now the Democratic Republic of Congo) they ran out of money and could not afford to buy the ink required to print more. 67.247.7.19 (talk) 16:09, 12 June 2011 (UTC)

The yield on sovereign debt is not the risk-free rate

Standard and Poors, Moody's, and Fitch all agree that there is risk in sovereign debt; why else would investors be interested in the sovereign credit ratings from the rating agencies? First, a sovereign cannot simply print its way out of debt without default. If a government prints its way out of debt, it will increase inflation and decrease the real value of the interest and principal payments on its debt. If an investor receives payments with a decreased real value, this is default by a different name. Second, just because a nation can print more money doesn't mean that it will print more money, and just because a nation has the resources to pay its debt doesn't mean that it will pay its debt. Ecuador defaulted on its debt in December 2008, even though Ecuador had the resources to pay. Ecuador defaulted for "moral reasons". In 2011, many U.S. politicians have considered defaulting on U.S. legal obligations, even though the U.S government has the ability to pay--at least as long as investors are willing to buy U.S. treasuries.

References

Proxy

Practical and theoretical problems of risk free proxy Fredrick Kimath (talk) 21:21, 9 May 2019 (UTC)

Risky assets do not have to have a better rate of return

The introductory paragraph states that "Since the risk-free rate can be obtained with no risk, any other investment having some risk will have to have a higher rate of return in order to induce any investors to hold it." This is not correct.

There exist assets (most prominently formal insurance, but also any other asset that correlates with "bad" states to which economists refer to as insurance) that have a lower expected rate of return than the risk-free asset, but yield a higher rate of return in "bad" states and are thus chosen by investors despite being "risky" in the sense that they yield state-dependent payoffs.

As an example, the Consumption-CAPM model argues that "expected risk premium on a risky asset, defined as the expected return on a risky asset less the risk free return, is proportional to the covariance of its return and consumption in the period of the return". Since the covariance can be negative too, a negative risk premium is a possibility. A similar effect can be found in the case of formal insurance, where many individuals would accept even actuarially unfair insurance to hedge risks.