Estimating Risk free Rates
Models of risk and return in finance start off with the presumption that there exists a risk
free asset, and that the expected return on that asset is known. The expected return on a
risky asset is then estimated as the risk free rate (i.e., the expected return on the risk free
asset) plus an expected risk premium. In practice, however, there are two major issue that
we have to consider when estimating risk free rates. The first relates to the definition of a
risk free security, and the characteristics such a security needs to possess. The second
applies when there are no risk free assets, and examines how best to estimate a risk free
rate under these conditions. We attempt to deal with both these issues in this paper.
The Risk free Rate
Most risk and return models in finance start off with an asset that is defined as
risk free, and use the expected return on that asset as the risk free rate. The expected
returns on risky investments are then measured relative to the risk free rate, with the risk
creating an expected risk premium that is added on to the risk free rate. But what makes
an asset risk free? And what do we do when we cannot find such an asset? These are the
questions that we will deal with in this paper.
What is a risk free asset?
To understand what makes an asset risk free, let us go back to how risk is
measured in finance. Investors who buys assets have a return that they expect to make
over the time horizon that they will hold the asset. The actual returns that they make over
this holding period may by very different from the expected returns, and this is where the
risk comes in. Risk in finance is viewed in terms of the variance in actual returns around
the expec ...