Does a Risk Free Rate Really Exist?
Posted on | February 18, 2010 | No Comments
I was perusing Musings on the Markets, Damodaran’s blog and came across a post entitled Thoughts on the Risk Free Rate. Perhaps, because I am not an academic, I usually reject ideas that seem contrary to logic or that seem designed for an academic and not practical use. The Risk Free rate is one of these notions. This is of course not a reflection on Damodaran’s work. I am a fan. The concept of the risk free rate does not originate with him. It seems to be part of the whole Modern Portfolio Theory bag of tricks. And although it is used as a basis for the Black Scholes option price model and for calculating the Sharpe Ratio, I do not think the risk free rate actually exists. It is a theoretical construct that enables people to compare rates of return, on a theoretical risk adjusted basis. As I have written before, I am not interested in theoretical returns on my capital, but real returns.
What is the risk free rate? It is the rate of return that you can get without any default risk, that would be guaranteed for certain period of time. Investopedia says, “In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.” Ordinarily, in the United States our 3 month government t-bills act as the risk free rate, according to Investopedia.
I prefer not to divorce myself from the concept that long tail or Black Swan Events are always possible, if unlikely. By definition, risk cannot be assumed away in the real world, without ignoring unlikely events. I like them to be included in all my thinking. It forces me to always think of the downside. I am fairly risk averse. I look for a margin of safety, because I am likely at some point, to be wrong, or not have analyzed some aspect of an investment correctly.
In a post on Investing Risk, I laid out a couple of ideas concerning investment risk, including the concept that there are some risks that we may not know, or anticipate. Because we are unaware of a risk does not mean it doesn’t exist. That is the problem with risk free rate, it assumes away the unknown, or unknowable. That does not mean risk has disappeared, just that we are ignoring it.
Related Posts:
Comments
Leave a Reply
Subscribe to Chroma Investing
