Thursday, May 27, 2010

What IS risk-free?

I'm conducting a review of a client's performance reports. When reporting by country, if there is no risk-free rate for that country, a zero value is used (e.g., for Sharpe ratio, Jensen's alpha). Why?

Risk-free rates can be quite complex; perhaps more than they need to be.

I'm a US-based investor. My risk-free rate is the U.S. Treasury bill. I can put my money there or invest in something more risky, such as Vietnam equities. Vietnam, to my knowledge, has no risk-free rate. But why should I care; would I invest in them? No, if I'm looking for a risk-free rate it's treasuries.

Well, what about the investor in Vietnam; what if he's your client, what do you show? I'd pick a risk-free rate that this investor could invest in; since there is no rate for Vietnam, perhaps one from Australia, the UK, or the USA? Pick something that could be used, but don't look for a collection of rates, one per country. The rationale behind this is lost on me. If you have a good argument for it, let me know.


  1. Hi David...I am following your blogs since past few months...needless to say, they are really very helpful...

    How about taking an average of the risk free rates of similar countries having similar economic characteristics as Vietnam (in this case)?

    Rishi Gajbhiye

  2. Rishi, thanks for your note and post.

    My point goes beyond countries that don't have their own risk free rate. Let's say that your client is US-based and that you invest in the UK for them: would you use the UK risk free rate? I'm sure many (perhaps even most) do; but why? I guess it's a matter of perspective. If I'm saying "instead of buying the UK corporate bonds I could have put you into a UK risk-free investment," then there's some value; or, if I say "instead of buying you the UK corporate bonds I could have put you into a US risk-free asset." Which makes more sense?

    The whole issue of "risk premium" is one that is somewhat controversial. Is the "risk free rate" that of the investment (i.e., the risk-free option in the issuer's country) or of the investor?

    If it's of the investment, then what you suggest might work, and then it's a matter of coming up with something that you feel is appropriate; if it's the investor, then it would be their home country.

    Part of this post was me "thinking out loud." I appreciate your comment and would have hoped others would chime in w/their thoughts on this, too.


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