CAPM
- Thread starter NTP
- Start date
It depends which risk free rate you are using a 1 yr treasury bill rate or a 10 yr Treasury bond rate.
otherwise We assume only a single risk free rate in the CAPM model.
thanks
otherwise We assume only a single risk free rate in the CAPM model.
thanks
Backwardation
Member
But it is possible to have a different (risk free lending) and a (not risk free) borrowing rate (CAPM deviations). In this case, we have two intercepts of the SML on the Y-axis.
NTP
are you referring to Nominal and Real risk free rates ?
Expected return from an asset with zero beta risk is the risk free rate which is used for estimating the cost of equity in CAPM.
Reltaionship between Nominal and Real Risk free rate is:
Real risk free rates = Nominal risk free rates - Inflation (currency adjustment , if any may also come into the picture)
are you referring to Nominal and Real risk free rates ?
Expected return from an asset with zero beta risk is the risk free rate which is used for estimating the cost of equity in CAPM.
Reltaionship between Nominal and Real Risk free rate is:
Real risk free rates = Nominal risk free rates - Inflation (currency adjustment , if any may also come into the picture)
chiyui
Member
In principle, there is only 1 risk-free rate. If not, you can make free money by arbitrage, which will push the 2 risk-free rates discrepancy to zero. For example, if risk-free rate A = 2%, risk-free rate B = 2.5%, then you can just borrow $$ at A = 2% and invest those $ at B = 2.5%, thus earning a profit of 0.5% (notice that those money does not belong to you, but the 0.5% profit belongs to you!)
Below is just my personal opinion. I'm not sure if my thinking is correct or not.
-------------------------------I'm a separating line-------------------------------
In reality you can't really find a rate of return that is truly risk-free. Even the T-bills contain some credit risk (no matter how tiny it is, it just exists), inflation risk (which is not easy to estimate), and liquidity risk (T-bills is highly liquid, but there is still a tiny risk). So strictly speaking, the least risky T-bill is still not free of risk.
If you really want to have a "true" risk-free rate, you may proceed as follows. Construct a hedging portfolio by using stocks, bonds and options. This portfolio is risk-free, and will generate a risk-free return. You may consult the Black-Scholes-Merton theory of option for details (and actually these guys really did these transactions in LTCM).
But actually, one can still argue that the return of this hedging portfolio is still not risk-free (I'm not going to explain in details, which requires tons of time and space).
-------------------------------A fairy is passing here-------------------------------
Therefore, you see people in reality use some easy proxies for the true risk-free rate. For example, T-bills, zero-beta portfolio, LIBOR, repo rates, etc. But actually none of them are "truly" risk-free in principle. It just turns out that these proxies are very close to each other (or at least their movements are very close to each other), and this result does not affect the CAPM calculation significantly. So that's why people use them.
Below is just my personal opinion. I'm not sure if my thinking is correct or not.
-------------------------------I'm a separating line-------------------------------
In reality you can't really find a rate of return that is truly risk-free. Even the T-bills contain some credit risk (no matter how tiny it is, it just exists), inflation risk (which is not easy to estimate), and liquidity risk (T-bills is highly liquid, but there is still a tiny risk). So strictly speaking, the least risky T-bill is still not free of risk.
If you really want to have a "true" risk-free rate, you may proceed as follows. Construct a hedging portfolio by using stocks, bonds and options. This portfolio is risk-free, and will generate a risk-free return. You may consult the Black-Scholes-Merton theory of option for details (and actually these guys really did these transactions in LTCM).
But actually, one can still argue that the return of this hedging portfolio is still not risk-free (I'm not going to explain in details, which requires tons of time and space).
-------------------------------A fairy is passing here-------------------------------
Therefore, you see people in reality use some easy proxies for the true risk-free rate. For example, T-bills, zero-beta portfolio, LIBOR, repo rates, etc. But actually none of them are "truly" risk-free in principle. It just turns out that these proxies are very close to each other (or at least their movements are very close to each other), and this result does not affect the CAPM calculation significantly. So that's why people use them.
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