A recent academic paper explores what happens to finance without a risk-free rate.
Investigating further the idea that corporate debt is coming closer to sovereign debt (see here), we stumbled upon a recent paper by NYU Finance Professor Aswath Damodaran, “Into the Abyss: What if nothing is risk free?”
We were first introduced to Prof. Damodaran’s work via a Deutsche Bank presentation to The NeuGroup’s Treasurers’ Group of Thirty (T30) in January 2009 on estimating the equity market risk premium. Since that time, financial crisis lessons have evolved to cover the dangers of sovereign debt and the real fear of government default—calling into question the notion of risk-free investments with their risk-free rate of return.
Given Prof. Damodaran’s ongoing research into this theme, it is interesting to consider his perspective on the importance of the risk-free rate and how finance and investment theory will be disrupted if no risk-free rate can be found. His conclusions suggest a profound impact for capital structure, investment decisions and even derivative use.
The impact of no risk-free investments
If fear of government default rises for more and more countries, finance professionals will have to turn more and more to alternative and more uncertain estimates of risk-free returns. Among other things, this could lead to:
- Less asset-class diversification. Risk-free rates of return are critical for Markowitz portfolio theory and the efficient frontier for investment returns (and hence asset allocation). “Without a riskless asset available for adjusting risk, investors have to tailor portfolios to their specific risk needs. In practical terms, this would require investors who want to bear more (less) risk holding stocks in the riskiest (safest) sectors and avoiding safe (risky) companies.” In other words, less diversification.
- Higher risk premiums, volatility and less risk appetite. Psychologically speaking, not having a riskless investment or safe haven can be unsettling for investors, according to Prof. Damodaran, and may lead them to “invest less in risky assets, demand higher risk premiums (and pay lower prices) and be quicker to flee these assets in the face of danger.” In short, they will be less willing to take risk.
- Abnormal or irrational pricing. The desire for a safe haven will lead investors into investment scams, or at least irrational pricing of assets to make them appear risk-free. In all likelihood, these will come in the form of derivatives or structures products whose real value will be difficult to price without reliable risk-free rates to plug into pricing models.
- More importance placed on cash investment. The impacts on corporate finance decision-making without a reliable risk-free rate will be numerous. Among the most interesting impacts offered by Prof. Damodaran, given the current corporate cash hoarding, is the likely increased importance of cash investment management and an end to simply parking excess cash in Treasuries and ultra-safe money market funds.
As Prof. Damodaran explains: “When there is no risk-free asset, any cash held by the company has to be invested in ‘risky’ assets and the quality of the investment will be judged by the returns earned, relative to the required return (given the risk). Companies that find better cash investments will therefore be viewed as more valuable than companies that do not.” Indeed, he notes that some companies, “may generate more excess returns on their cash investments than on their operating investments” and thus would allocate and time and resources accordingly.
- Greater pressure to return cash. The flipside, unfortunately, is that companies that do a poor job of generating returns on their cash will be under even more pressure to return cash to shareholders—or see their market values severely discounted if they don’t.
- Less debt capacity. Without risk-free investment options to park cash on the balance sheet, the concept of net debt falls apart. Thus, the debt capacity of many firms would be reduced.
Since, as Prof. Damodaran highlights, having an investment that is risk-free is critical not only for financial modeling and corporate finance analysis, but also for investor behavior and the psychology of the marketplace. Given the latter, not all the impacts of eroding confidence in government debt, and hence risk-free investment benchmarks will be predictable or even rational. That should be reason enough for governments to do all they can to mitigate fears of default.