The interest rate that can be obtained by investing in financial instruments with no default risk is referred to as the risk-free interest rate. However, other types of risk could be carried by the financial instrument, e.g. market risk (market is the risk of changes in market interest rates), liquidity risk (liquid risk is the risk of being unable to sell the instrument for cash at short notice without significant costs), etc.
Risk-Free Assets
Though it is true that a truly risk-free asset exists only in theory, while in practice short-dated government bonds of the currency in demand is used by most professionals and academics. Usually US Treasury bills are used for USD investments, while German government bills or Euribor rates are a common choice for EUR investments. During the 20th century the mean real interest rate of US treasury bills was 0.9% p.a. (Due to hyperinflation during the 1920s corresponding figures for Germany are inapplicable.)
Due to the reason that the likelihood of these governments defaulting is extremely low, these securities are considered to be risk-free, and and it is also because the short maturity of the bill protects the investor from interest-rate risk which is present in all fixed rate bonds (if soon after the bill is purchased interest rates go up, then the investor will miss out on a fairly small amount of interest before that the bill matures and it can be reinvested at the new interest rate).
As this interest rate can be obtained without any risk, so that is why it is implied that any additional risk that an investor take should be rewarded with an interest rate higher than the risk-free rate (some local government US bonds give below the risk-free rate on an after-tax basis, which may be achieved with preferential tax treatment).
Application
In general the risk-free interest rate is thus of great importance to Modern Portfolio Theory, and for rational pricing it is an important assumption. In financial calculations also it is also a required input, such as the Black-Scholes formula for pricing stock options and the Sharpe Ratio. Here you should note that it is assumed by some finance and economic theory that market participants can borrow at the risk free rate; in practice, of course, there are very few borrowers who have access to finance at the risk free rate.
Why Risk-Free?
There is an explanation for the assumption that no default risk exists is due to the nature of government debt. For a fiat currency, the theoretical capacity is retained by the government to print as much of that currency which will be required to pay its own debts (in that currency). In this case, theoretically true default is impossible: owners of government debt can always be paid, but they will be paid with money that may have substantially lower value. The risk-free interest rate rather than reflecting the default risk of the government,therefore, reflects the likelihood that the government will print money to pay its debts, thereby reducing the value of the currency. Here you should note that this does not apply to currencies such as the Euro where no individual government has the authority to print currency. Of course, several countries have other measures and institutions (such as theoretically independent central banks) in order to reduce the likelihood of such an occurrence.
Alternatively there is another interpretation and that is, while no investment is truly free of risk, such possible events in which a major government which is having a long track record of stability defaults on its obligations are so far outside what is known that one cannot make quantitative statements about their chances of happening, and therefore to include them in financial planning is simply not feasible . A German investor living circa 1904 is trying to decide that whether to purchase long-term bonds issued by the German government could scarcely have been able to expect a World War that is followed by hyperinflation.
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Posted by R. MAK. in Currency Rates, Currency Trade, Forex Basics, Forex Facts, Forex Market, Forex trading, Trading · 0 Comment
