Saturday, July 24, 2010

What if nothing is risk free?

Every discipline develops its own dogma and finance is no exception; we make assumptions about how markets are structured and investor behavior that underlie much of our theory. Those within the discipline either take these fundamental assumptions as given or are reluctant to question them. Over the last few months, I have been working on a new book titled "What if?", where I am looking at how financial theory and practice would change, if the bedrock assumptions of finance were violated or no longer true. I just finished my first installment, where I look at how investment practice and corporate finance would change if there is nothing that is guaranteed or risk free. You can get the paper by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164

In an earlier post, I examined the mechanics of how best to estimate the risk free rate when there is no default free entity. Through most of that post, I focused on emerging markets, where governments are often prone to default, but left untouched the basic presumption that developed market governments like the United States, UK and Germany are default free. But that presumption has been put to the test by the banking crisis of 2008 and the Greek default drama of 2010.

I start by looking at how the presence of a risk free investment changes the way in which we construct portfolios and make corporate finance decisions. In particular, the presence of a risk free investment allows for separation between risk preferences and portfolio composition. Thus, two investors with different degrees of risk aversion can end up holding the same portfolio of risky assets and adjust for risk, by altering the proportions of their wealth that they put into the risk free asset. In corporate finance, the presence of a risk free investment can alter investment, financing and dividend policy.

So, what makes for a risk free investment? The issuing entity has to have no default risk, which restricts us to government securities, because governments alone have the power to print currency. The catch, though, is that governments sometimes default. While the explanation for default is simple, when governments borrow in foreign currencies, it is more complex when governments borrow in their own currency. The trade off that leads to domestic currency default - the debasement of the currency that comes with printing more currency versus the pain of default - has resulted in governments defaulting on local currency borrowings. If the probability of such default exists, even if slight, government bond rates are no longer risk free.

The most common and widely used measures of government default are sovereign ratings from S&P, Moody's and Fitch. While ratings and default rates are highly correlated over time, suggesting that ratings agencies do a good job, on average, there is also evidence that ratings changes are lagging indicators. An alternative measure of sovereign default risk comes from the Credit Default Swap (CDS) market, where investors can buy or sell insurance against default by governments. CDS prices tend to update faster than sovereign ratings, but come with more volatility.


The absence of a risk free investment can have significant effects on both portfolio management and corporate finance. When investors lack a safe haven, they will  become more risk averse and charge higher prices for risk. Higher prices for risk will translate into lower prices for all risky investments; we should expect to see stock prices and corporate bond prices decline. When firms have no risk free investments, lenders to these firms will be more wary about lending to them (leading to lower debt ratios) and investors may be less inclined to allow companies to accumulate cash (since that cash will be invested in risky assets).

25 comments:

Michael said...

Risk free = no correlation to all other asset classes, which means beta = 0. I have never thought that this assumption is true for government bonds -> my understanding is that government bonds are only proxies for risk free investments, because it is not possible (too expensive) to build a portfolio with a beta of 0. So, it has never been a problem that government bonds are not really risk free investments, but only proxies.

lucky_idiot said...

Prof. -

1) would pure gold (or any other real asset capable of holding its value and not susceptible to debasing / depreciation) be a risk free asset?

Admittedly, it won't / mayn't yield anything. Would that also drive the expected returns down even though the investors will not lose their money?

2) Also, doesn't the current practice of using yields on sovereign debt as a proxy of risk free rate implicitly admit pricing the default by sovereign?

"Shouldn't" a true RF asset neither default nor is required to yield anything?

The only "escape route" I could think of was the behavioral one - humans need incentive to save & hence, an RF may have to provide yield.


@Michael - Isn't a risk free asset one that when held till maturity (or end of investment period) will return the principal?

If we agree on that definition, wouldn't intra-period market risk / interest rate risk / correlation risk etc. be meaningless?

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blindinvestor said...

Great article - just finished reading the 55 pages. I discussed the death of the risk free rate in my blog recently - "R.I.P. Risk Free Rate" http://bit.ly/bYyJKh, but not nearly as in-depth and well thought out as you have.

Aswath Damodaran said...

First, in response to the comment that all you need is a zero beta asset for a risk free investment. That is not true and here is why. A lottery is a zero beta investment; it's payoff is unccorrelated with the market but it is definitely not riskfree. On the question of gold, I am conflicted. I think that the absence of a riskfree investment will send investors in search of something guaranteed and gold has historically fulfilled that need.. So, that may explain the surge in gold prices.

Jose Augusto said...

Don't you think that default of the treasury would be such a catastrophic scenario that modern corporate finance would not be applied?

Aswath Damodaran said...

Most of the world (or at least emerging markets) has operated with the assumption that governments can default and corporate finance is still practiced. You cannot suspend corporate finance, since that would mean that companies do not make new investments, set financing mixes or pay dividends. You can modify the theory and practice of corporate finance to allow for government default and that is what I have tried to do.

Michael said...

You are right. What matters is not only no correlation with other risky assets, but also a guaranteed return. If the return is guaranteed, there should be no correlation with risky assets. Furthermore, there should also be no reinvestment risk -> use of spot rates.

One thing I have to mention: thanks a lot for all your work you are sharing with us. You also have a great homepage with a lot of very helpful information!

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NK said...

Dear Prof.-

As you correctly mentioned, the price of an asset equals its real price plus the risk (volatility) associated with it. Hence with CDS gaining acceptance, the price of risky assets should come down. But has it been really the case, say in US, did the real asset prices fall as CDS got wider acceptance. I'm asking this as the RBI (India) is looking at introducing vanilla CDS of corp bonds for now, in a narrowed down, controlled manner. What's your view there. Thanks.

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Puneet said...

Prof:

If there is no safe haven of treasuries in developed markets, then what exactly are we measuring. Presumably, all emerging markets are correlated to mature markets for funds. So can't we move forward by just revising our risk aversion. Like during the crisis of 2008, companies were trading below their intrinsic values, till date there is no clarity on the state of the economy, Investors have just raised their trading multiples. Accepting more risk for investments made. My whole point is if the most powerful nation's currency is not risk free, then the bar for risk has to go up and we start trading in a environment of higher market multiples for equities and ask for higher interest rates on bonds. I know i have linked a lot of variables, but the fact of life is the whole world for the next 10 years is dependant on US. Probably after a few years the authority of supreme power could be pushed to China. Here again the problem is China itself is dependant on US for most of its growth. So how do we trade from here if there is no safe haven, are we on the brink of worldwide collapse and then there is survival of the fittest?

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Himanshu Kundoo said...

Prof.

I have a question??

does risk free rate depend on the home country of the investor. For eg in an US investor will invest in india use a different risk free rate as compared to an indian investor.