The Concept of a Risk-Free Rate is Flawed

By: Daniel Aaronson & Lee Markowitz | Fri, Mar 5, 2010
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The valuation and stability of all financial markets have been enhanced by the universal belief that US government bonds represent a risk-free interest rate. However, the notion that a bond can be risk-free is misguided. The recently heightened public awareness of sovereign risk and the potential for sovereign defaults in the future (Figure 1) ultimately will force investors to recognize that the use of a risk-free interest rate to value financial assets is flawed.

Figure 1. Sovereign Defaults Should Boom

Source: Elliott Wave Financial Forecast

Nearly all asset pricing models use, directly or indirectly, a risk-free rate to derive financial asset valuations. Although there is a growing minority who claim that US government bonds are not risk-free, as indicated by the existence of US credit default swaps (that are actually rising), market valuations and sentiment to do not support this view. Investors continue to view the investment world as it has operated during the past 30 years rather than recognize how significantly the landscape has and continues to change because of sovereign risk. When subprime problems first appeared, investors and central banks believed that the problems would be contained and could be easily managed. Today, the same complacency sets the backdrop for sovereign debt issues. When markets embrace a risk premium for US government bonds, the effect on the pricing of all other risk assets (stocks, bonds, real estate) will be even more severe than what was seen in the fall of 2008.

 


 

Author: Daniel Aaronson

Daniel Aaronson
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

Copyright 2009-2012 © Continental Capital Advisors, LLC

Author: Lee Markowitz

Lee Markowitz CFA
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

Copyright 2009-2012 © Continental Capital Advisors, LLC

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