What Is Risk-Free Rate?

Let's begin with RISK-FREE RATE 101 class. (Prerequisites: Default-free, Treasury, Safe, Secured)

2 years in the business school and reading all those books of CFA program curriculum. The most repeated term has been- Risk-Free Rate (Rf). It is considered as yield of US Treasury securities. US Government is (was?) considered as default-free thought it fought hard to prevent default recently. Whenever global economy melts or shakes, investors look for Treasury securities. They have been known as the safest investment since there is no volatility or risk included. We employ many risk-return tools (for example, Sharpe Ratio) to calculate excess return achieved by investing in particular assets. This excess return is calculated by considering risk-free rate as benchmark. Many countries with political instability and higher inflation rates do not have their risk-free rates. They add their inflation rate to US risk-free rate to get the benchmark rate for their country. And thus long-term bond yields and so on. This is what the biggest economy stands for.

But in the recent turmoil, I am not able to believe completely that we should still use Treasury yields as risk-free rate or not? I do not want to discuss why S&P has recently downgraded US credit ratings to AA+ from AAA. It may be reversed or may be not. S&P might be wrong in deriving this verdict or they might be late in doing this. I do not know the facts. But few things I surely know that there are few problems in Washington DC. There are serious fiscal challenges we have been facing. Looking at the current scenarios, US may not deserve AAA. But when country has to put efforts to prevent default which US did last week, their risk-free rate should not be considered as default-free rate or benchmark rate. Why can't we change that? Why can't we use risk-free rates from countries like UK, Germany and Canada who still have AAA?

I am not sure about literature we used in the business school, but CFA institute updates its books every year based on recent market conditions. I will not be surprised if I see Canadian rates as risk-free rate in those books next year...

8.9, Earthquake, Tsunami, Japan, Economy and the US

"Jasmine Revolution" began in Tunisia in the early 2011 and it rippled across the Egypt, Libya, Bahrain and the other middle east countries. I believe that's what we have been listening to and watching since last two and so months. And suddenly, a 8.9 magnitude quake and tsunami hit the Japan- the world's third largest economy. Though Japan is located on one of the most active geological fault lines, it experienced one of the biggest quake in its history and the most severe after the Kobe. The worst situation this quake followed by tsunami created is  "The Nuclear Explosion". And the country is trying hard to prevent its spreading along with other rescue efforts.

Looking at Japan's standing in the world economy, the ripple effects of this natural calamity are as horrified as expected. It may likely to impair nascent economic recovery in the developed markets. I have come across few areas where the US have some potential or immature impacts from this disaster.

• Borrowing cost of US Treasury securities: Japan needs handsome capital to trigger reconstruction and recovery efforts though Bank of Japan has recently infused cash in to the economy following the quake. As Japan is the second largest holder of US Treasury securities after China, it may sell those to get capital it needs. In that case, borrowing costs or rates may be increased to lure investors in the global markets. On the contrary, investors have responded by huge sell off globally and by dumping the risk assets. Their demand for safe haven- US Treasury securities seem to be increased.
• Money managers' holdings: Money managers across the globe will likely to face short term losses from their holdings in Toyota, Canon, Hitachi and other Japanese companies. These losses are strictly being considered as short term because of global presence of these companies.
• Pharmaceuticals: Japanese pharmaceutical market is the second largest market after the US and it is expected to grow at the highest rate among the developed markets. For example, Pfizer gets his $5-$10 billions of revenues from Japan alone. Such a high correlation could slow down the industry growth.
• High end retailers: Japan is one of the huge market for high end products. To name a few, US based retailers like Tiffany, Callaway Golf, Coach may be the worst hit high end retailers in the first two quarters of this year because of potential squeeze in consumer spendings in Japan.
• Tourism: Based on some news & research, Japanese travelers contribute approximately 20% to the tourism in Hawaii. Looking at the potential ebb in spending patterns in Japan following this disaster, Hawaii tourism may likely to see some fall.

I wish and pray for their safety and well-being.