What is the risk free rate?

The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books.

This week, that conventional wisdom was challenged for the first time. After the Federal Government stepped in to provide a backstop to AIG, and then later in the week, for an even larger package of mortgage backed securities, there was a sense in markets that the rules of the game had changed. In the Credit Default Swap (CDS) market, where investor buy and sell insurance against default risk, the price for insuring against default risk in the treasury climbed to 0.25%, on an annual basis, on September 18, 2008. While it is possible that this was an over reaction to the tumult of the week, that number should give us pause. If true, the true long term riskfree rate in U.S. dollars on September 18 was not the 10-year treasury bond rate of 3.77% but the default risk adjusted rate of 3.52% (3.77% - 0.25%).

I will wait and see what the next few weeks bring. It may be time to rewrite finance textbooks to reflect the new realities.