Risk Free Rate

[atandon]

Hi David,

I am referring to 2012.T3.Products.pdf on page - 32.

I am not able to understand the mind set behind the following statement -

Traders argue that Treasury rates are too low to be used as risk-free rates because:

1. Market demand: Treasury bills/bonds must be purchased by financial institutions to fulfill a variety of regulatory requirements. This increases demand for these Treasury instruments driving the price up and the yield down.
2. Regulatory relief: The amount of (regulatory) capital required to support an investment in Treasury bills/bonds is substantially smaller than the capital required to support a similar investment in other instruments
3. Tax treatment: In the United States, Treasury instruments are given a favorable tax treatment because they are not taxed at the state level.

Could you pls explain how these 3 points (specially 2&3) are a disadvantage to a trader.

Many Thanks,
atandon

 

[Aleksander Hansen]

Not necessarily a disadvantage per say, but the rate is artificially low, and/not representative.
Thus, the risk-free rate (which is important when valuing pretty much anything) is not equal to this rate.
Arbitrage arguments would no longer apply for example and if you throw that out the window you're left with pretty much nothing.
It is imperative that you use the risk-free rate for valuation.

That being said, the GARP material is dated, LIBOR is not a risk free rate either, in fact it has a time varying risk premium which can sometimes be huge.

If you want to value something and need the risk free rate you use the OIS (overnight index swap)

 

[David Harper CFA FRM]

Atandon,

Those three points are from Hull (Snapshot 4.1). Notice they all basically refer to dynamics that increase demand, ceteris paribus, for Treasuries. So, the point is that demand may artificially lower the rate.

Re true rate, ahansen is right as usual. And Hull makes this point is the latest (8th) version, I think Hull only implies that traders abandoned LIBOR due to its spiking during the crisis (i.e., manifesting counterparty and/or liquidity premiums). On top of that, we can add the recent quasi-scandal concerning the objectivity of LIBOR given it's set by a relatively small panel. But in the 8th Edition, Hull does say that OIS is now preferred.

 

[atandon]

Thanks