Saturday, September 20, 2008

What is the risk free rate?

The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books.
This week, that conventional wisdom was challenged for the first time. After the Federal Government stepped in to provide a backstop to AIG, and then later in the week, for an even larger package of mortgage backed securities, there was a sense in markets that the rules of the game had changed. In the Credit Default Swap (CDS) market, where investor buy and sell insurance against default risk, the price for insuring against default risk in the treasury climbed to 0.25%, on an annual basis, on September 18, 2008. While it is possible that this was an over reaction to the tumult of the week, that number should give us pause. If true, the true long term riskfree rate in U.S. dollars on September 18 was not the 10-year treasury bond rate of 3.77% but the default risk adjusted rate of 3.52% (3.77% - 0.25%).
I will wait and see what the next few weeks bring. It may be time to rewrite finance textbooks to reflect the new realities.

8 comments:

Arocks said...

Dear Professor

what can explain the default spred of 250 basis points on T bonds?Is it the risk aversion? or The implication of US fed and treasury bailing out US institutions and its long term effect on US Dollar? or something else?

Student said...

In my opinion, as long as U.S. government debt is dollar denominated, there isn't any default risk. In my opinion, you'd have to be a fool to pay 25 basis points for that extra protection, because it only pays the nominal cash flows, not the real cash flows. Uncle Sam will inflate before defaulting. But maybe longer term risk free rates should have to take into account the possibility that the U.S. will no longer be able to issue dollar debt at some point in the future?

Currently, I don't think that your blog allows anonymous comments. You might consider allowing anonymous comments because many readers won't have a google aaccount or another blog service account.

I've been a frequent user of your texts and website for several years and thank you for your generosity in making so much valuable material freely available.

Pat L

crumpledbrownbag said...

I'm curious how/where did you find the information about the 0.25% default risk premium? Since most of us assume its zero, do they even measure it??
Thanks,
Sri

nikhil said...

Dear Sir,

First of all thanks a lot for sharing you thoughts in open.

But have a doubt, would like to know if the risk in US Treasury has increased, why would the rate decrease from 3.77% to 3.52%. If the risk increases, shouldn't the return expected ideally increase?

Dhananjayan said...

Sir, Congratulations and thanks for starting such a wonderful blog. I would like to ask u a question. In India, risk free interest rate is 8.24% (10 years govt bond rate) and the inflation is somewhere above 13%. Once in your class, you said that the default spread published by rating agencies on any country represents the inflation risk. Now in India, if you adjust this inflation on risk free interest rate, real rate of return is negative -4.76%. If this inflation is continuing for long time - say for another 3 years, what will be my risk free interest rate sir? How can I calculate my cost of equity in this case? Can I take risk free interest of 8.24% which could not even cover the inflation risk? Thanks in advance.

Starship trooper said...

Professor D - First off, thank you for starting this blog at such an "interesting time" in the financial markets. I've been a long time user of your texts and website and I look forward to reading your thoughts.

To nikhil: The risk free rate is lowered in this situation because you are paying .25% in order to gain the "risk free rate" of 3.77%. So in reality the market is telling you that the true risk free rate isn't what the nominal yield is on the gov't treasury bond. Hope that helps.

Miguel said...

Dear Professor Damodaran, good morning.

What is the effect on valuation when it happens that you have a negative real rate as the government bond.

(Inflation is estimated higher than the nominal Bond for a country.)

During this crisis, this happened for some countries namely if i am not mistaken Russia.

What should you do in these cases ? Ignore the government bond and use other sources' real gpd growth as a proxy for the risk free? Is there any literature on this?

Thank you for your time

meghatayade said...

dear sir,

sir i wanted to know the risk free rate of return of india from 2006 till 2009. is it same throughout & how it is calculated?