What If Nothing is Risk Free?
What to do when no default free entities exist.
BY Caroline Cakebread | July 26, 2010
As pension funds struggle to de-risk, a new paper by Aswath Damadaran, Stern School of Business, asks whether or not any investment is risk free. And, if not, how do you estimate a risk free rate? The paper, “Into the Abyss: What If Nothing is Risk Free?” is summarized as follows: In corporate finance and investment analysis, we assume that there is an investment with a guaranteed return that offers both firms and investors a “risk free” choice. This assumption, innocuous though it may seem, is a critical component of both risk and return models and corporate financial theory. But what if there is no risk free investment? During the banking crisis of 2008, this question came to the fore, as investors began questioning the credit worthiness of US treasuries, UK gilts and Germans bonds. In effect, the fear that governments can default, hitherto restricted to risky, emerging markets, had seeped into developed markets as well. In this paper, we examine why governments may default, even on local currency bonds, and the consequences. We also look at how best to estimate a risk free rate, when no default free entity exists, and the effects on both investors and firms. In particular, we argue that the absence of a risk free investment will make investors collectively more risk averse, thus reducing the prices of all risky assets, and induce firms to borrow less money and pay out lower dividends.