Much modern investment theory rests upon the concept of a risk-free rate, but like other assumptions behind the capital asset pricing model et al. recent financial crises have served to highlight the risks of becoming complacent. Unlike the other assumptions however, the concept of a risk free rate is one that has broad reaching practical implications beyond the abstract world of academic theory: where exactly can I put my money and be sure of getting it back? Should I expect a return, and if so, what should that return be?
Recent market conditions have highlighted more than ever the difficulties in establishing what exactly constitutes a risk free rate of return. Traditional measures have been the rates at which banks lend to each other or the returns on short term government bonds.
Since the banking crisis of 2008 however, we have been reminded that inter-bank rates reflect the credit risks of the institutions themselves and that this is not always insignificant.
This is particularly evident in Europe today, both at the personal level, and at the institutional, as our colleagues at M&G bond vigilantes have recently highlighted. The traditional indicators of risk free rates of return, LIBOR and EURIBOR, are now reflecting the stresses of the financial system, while the recent scandal over LIBOR manipulation has revealed even more sinister concerns.
But what about the short term rates at which governments borrow? For countries with control over their own currency credit risk should not be an option. You simply print more money to pay-off debts. Again however, this is not a static assessment. Events in the Eurozone and the long history of sovereign defaults show that governments do not always have the ability or willingness to honour their debts.
The issues above are not a new development, we are simply more conscious of them now because of recent history. The reality is that nothing is ever truly “risk free.” When Greeks stuff money under the mattress it is predicated on the trust that someone will want to exchange something for that money later on. Ditto for when people talk of “the new calculus of gold;” gold is only more risk free than anything else as long as people perceive it to be so. Nor is this a call for investment in shotguns and canned food, my cash was still valid (in most establishments) last time I checked. Rather, it is a note that we should be conscious that riskiness is not static and seek to avoid complacency when assessing the safety, or otherwise, of our investments.