By Joseph Neu
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, 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 at a NeuGroup Treasurers’ Group of 30 (T30) peer group meeting where Deutsche Bank presented on estimating the equity market risk premium. Since that time, the 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 his 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 on capital structure, investment decisions and even derivative use.
Defining risk-free
To help understand the impact of having no risk-free rate to anchor financial decision-making, Prof. Damodaran’s paper walks through how governments can default and how to estimate a risk-free rate when there is government default risk. He also provides a helpful definition:
“Risk in finance is viewed in terms of the variance in actual returns around the expected return.” Therefore, according to Prof. Damodaran, “for an investment to be risk free in this environment…the actual returns should always be equal to the expected return.”
Two conditions, he notes, need to be met to achieve this: (1) there can be no default risk (which limits risk-free investments to governments that can print currency to repay their debts) and (2) there can be no reinvestment risk (hence, a six-month risk-free rate cannot be risk free for a five-year period; nor can a normal 5-year Treasury note, since the coupon payments are subject to reinvestment risk; this leaves the zero coupon bond for the periods as the only risk-free investment).
If governments can default on their debt, as indeed they can and have in ways the paper outlines, then their debt can no longer be used to define a risk-free rate of return and form the benchmark for calculating risk premiums. Where a risk-free rate is not found in government debt benchmarks, Prof. Damodaran offers a few imperfect alternatives to measuring the risk-free rate. Most are more applicable to emerging market scenarios than, say, a US default.
For example, if you have the risk-free rate in one currency of a pair, you can use forward or futures pricing to back out a rate on the other currency. Another common method is to estimate the default risk component of the market rate and back-out the risk-free rate.
no risk-free investments Impact
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) riskholding 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 he explains: “When there is no riskfree 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.”
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.