Thursday, July 28, 2011

You ever hear of the risk-free rate?

The risk-free rate is also known as the 3-month U.S. treasury bill!

What happens if and when there is no risk-free rate?

Will that happen when the United States is downgraded from AAA?

What will happen to the CAPM?

When I was in business school one of the major concepts included an esoteric formula known as CAPM, or the capital asset pricing model.

Long story short the CAPM was a risk/reward tool through which an investor could determine whether the expected return from an investment was worth the risk of that investment.

CAPM calculated a risk premium over the risk-free rate that an investor should demand from an investment in order to invest.

This risk premium would be the investors compensation for getting involved in a risky investment rather than simply investing their money risk-free.

Capital Asset Pricing Model (CAPM)

Required or expected return = Risk-free rate + (market return - risk-free rate) * beta

Consider the EU PIGS bonds and the massive risk premium that is currently being demanded by investors in order to entice them to buy.

Long story short, what happens if and when there is no risk-free rate?

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