What should we use as the risk-free rate

[skthewimp]

The cost of credit default swaps (CDSs) for 10 year US Treasury bonds have reached an all-time high, trading at as high as 24 basis points. In this regard, what should we use as the risk-free rate

Comments

[nandu1]

Hi, recently came across your blog - and ended up adding it to my feedreader....!!

I'm assuming you're evaluating an investment decision in the US in the first place. Have you considered using yields on bonds issued by other governments (any country that could be considered less risky than the US from a credit default perspective) + an adjustment for currency risk based on a locked-in 10 year forward contract?

Of course, efficient markets theory indicates that you should end up at US risk free rate minus the spread on CDS, but if markets were always efficient, there would be no arbitrage traders!

[skthewimp]

thanks; and now you have a new blog to add to your feedreader since I've moved;

i was just thinking about it from an investment banker's point of view from the US.

and I think it's the other way round - it's the presence of arbitrage traders that keeps markets efficient

[shrikanthk]

In valuation exercises, we use the historical equity risk premium over a very long period of time to determine cost of equity. That being the case, shouldn't we take the average historical yield on govt securities as the risk free rate instead of considering the current market yield?

[nandu1]

Shrikanth,

If you're looking to value an investment decision, with payouts over or at the end of a 10 year timeframe, would it not make more sense to consider what seems to be the most accurate information for the next 10 years, as opposed to historical trends over a 50-100 year period from the past? The long-term equity risk premium eliminates cyclicality concerns, but if the investment decision plays out over the next 10 years, then it is critical that this be taken into account. Equity valuations work based on a company surviving until eternity. I'm not sure if that is the timeframe we're considering here!!...:)