The risk-free rate and corporate finance

Discussion in 'Professional Trading' started by ASusilovic, Aug 4, 2010.

  1. THE sovereign debt crisis may eventually cause some re-thinking in academia. In corporate finance theory, the risk-free rate (that paid by governments) is the basis for pricing other assets, which must pay a risk premium on top of that. But what happens when the government, like Greece, has little hope of repaying its debts at market rates?

    One answer might be that all corporate entities in that country are dragged down with their government; this clearly applies to the banks. But that is not necessarily true for multinational companies which just happen to be domiciled in the country concerned. An answer to that conundrum would be to substitute a more creditworthy government for the local one, so that Greek multinationals are priced off German bunds or US treasuries. But there may be occasions when there is a currency mismatch.

    A related issue is the use of government bonds as the core holding for pension funds, on the grounds that these are the closest match to the company's liabilities. Again, it may be the case that, say, Shell's promise to pay its pensioners is stronger than the British or Dutch government's pledge to repay its debts in full. (There is a philosophical point, as well. The rationale for private sector pension funds is that they reduce the burden on future taxpayers. But a fund investing in government bonds is simply a claim on future tax revenues.)

    There may well be other implications that will become clear if, as Ken Rogoff argues in today's FT, the crisis leads to more sovereign defaults.


    So, the debt of the government of the US of A is not anymore risk-free / trsutworthy ? In this case, I would have a problem with my "asset pricing" models...:cool:
  2. You don't need a risk-free rate or your asset pricing model. It's always been an oversimplification. What you really need is your own funding rate, as that's really what matters.
  3. I meant to say "You don't need a risk-free rate for your asset pricing model". Typo here.