Sunday, August 7, 2011

Good-bye Risk Free Rate?

With the downgrade of US debt, one of the most frequently used benchmarks for financial valuation models is now somewhat suspect.
As we have discussed before, the risk-free rate is an important component in developing cost of capital estimates. We now need to think twice before automatically reaching for our Treasury yield curve for this value.
Yet do we?
Even for a triple-A rated entity, there is some sliver of chance that it will be downgraded. The ratings agencies publish transition matrices and default probabilities for this exact reason. It should therefore not surprise us that one issuer in this universe has been downgraded. It should surprise us more if there were never any downgrades from this set of issuers.
Let's remember that the risk-free rate is a theoretical construct. As has been discussed before, it doesn't have to exist in real life. In the theory, it is needed to distinguish the fact that an investor will earn some amount of return that is not associated with risk, while the remainder of expected return will occur in relation to the risks being taken.
So as a matter of convenience, US debt was taken as a proxy, but it has always been just that, a proxy. It never was the true risk-free rate, as in real life there is always a chance of default or loss.
So this weekend's action by S&P should not concern us that much. The risk was always there. A risk-free rate still exists in theory. You can still use US Treasuries as a proxy, but maybe adjust the risk premium component by a few basis points.
In spite of S&P’s action, a Treasury today is just as safe as it was yesterday, and there are not many investments out there that are safer.
I would love to hear your thoughts about the US Debt rating or your stories on this topic if you have them.
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