Risk Free Rate

Question 1

What is a risk free rate?

Answer 1

• Inflation needs to be considered, and cash rates do not keep up with the cost of living but FSCI means deposit accounts are largely default risk free.
• Long term deposit rates are at risk from negative real yields.
• Future trajectory of inflation cannot be known with certainity and histroy shows that bond returns are eroded by inflation.
• At times of unexpected inflation there are negative returns and conventional long maturity government bonds may therefore not be lowest risk, though in times of deflation they provide safety.
• Most likely security is a long-term inflation linked government bond as it moves away from nominal returns towards real returns.
• There always is the risk of deflation, so even inflation linked bonds are not risk free to long-term investor. There is also the problem that demand is so high for som eissues that the price makes the yield too expensive to worth purchasining.
• Ultimately, it is hard to find a completely risk free asset so looking for safe assets is likely to be more productive.
• This brings about the concept of a zero beta CAPM rather than a risk-free CAPM.

Question 2

What are the components of risk-free rates?

Answer 2

• Risk free rate assumes no default risk and returns that are uncorrelated with idisyncratic and systemic risk.
• One building block is a return for bearing illiquiduty, even if the lend this means forgoing alternative uses of funds for a very short period of time.
• Expected inflation, investors will require a return equal to expected inflation in order not to erod the purchasing power of money lent.
  
  • Change in expected rate of inflation will feed though to a change in nominal risk-free rate.
• Influence from the central bank tighness of money, will impact the real rate of economic growth.