{"id":5214,"date":"2012-03-20T23:59:16","date_gmt":"2012-03-21T03:59:16","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5214"},"modified":"2018-09-21T02:04:25","modified_gmt":"2018-09-21T06:04:25","slug":"rethinking-the-risk-free-rate-exploding-a-fundamental-assumption","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2012\/03\/20\/rethinking-the-risk-free-rate-exploding-a-fundamental-assumption\/","title":{"rendered":"Rethinking the Risk-Free Rate, Exploding a Fundamental Assumption"},"content":{"rendered":"

After the Great Recession (2008 to the present), it is in vogue to criticize the risk-free rate<\/a> of return as a spurious concept. This is not surprising given the twin sovereign debt crises of the European Union<\/a> and the United States; both countries\u2019 debt instruments previously served as proxies for the risk-free rate of return.<\/span><\/p>\n

Lost in the current discussion, and perhaps from the concept’s very intellectual beginnings, is an examination of first principles. Put differently, what exactly does risk-free mean? Is this measure philosophically sound and reflective of reality? Here is a rethinking of the risk-free rate that should help to frame discussions about rewards versus risks.<\/span><\/p>\n

First principle: Actions are always risky.<\/strong><\/span><\/p>\n

Why are actions always risky? Because the future is always unknowable. While it is appropriate to assign probabilities to uncertain outcomes, probability is in an asymptotic relationship to 100% certainty. Probabilities will never be 100%. One cannot even state with 100% certainty that there will always be change as, in the future, that may be the final change.<\/span><\/p>\n

Until an event has occurred the success of a probabilistic prediction cannot be measured. Due to the unknowable nature of the future, all actions always contain a component of risk. Confidence can only be stated in calculus-like terms: for example, \u201cthe probability of x <\/em>occurring approaches<\/em> 100%.\u201d<\/span><\/p>\n

Lying at the heart of this discussion is an implication: we live in a universe of action. When in history has there been a time when there was no action? Never.<\/span><\/p>\n

Rewinding effects back from their causes and all the way back through history leads to whatever came before the Big Bang. At this moment, if it can even be called a moment, there was no action and therefore no risk.<\/span><\/p>\n

Everything that we know subsequent to the Big Bang has involved unfolding action and, hence, risk. Risk is therefore inescapable as action is inescapable. As an investor, even doing nothing is a risk that we call an opportunity cost.<\/span><\/p>\n

Furthermore, any theory, no matter the discipline, and even including finance, must be in accord with the laws of nature. It does not make sense to talk of a risk-free rate of return and simultaneously associate that with an action \u2014 namely, investing.<\/span><\/p>\n

Second principle: Investing is always risky.<\/strong><\/span><\/p>\n

Investing is always risky, because investing is an act in which outcomes can only be stated at probabilities of less than 100%.<\/span><\/p>\n

Third principle: Expected return is the inducement for taking on risk.<\/strong><\/span><\/p>\n

What would induce an investor to surrender his\/her low-risk liquid position? Higher expected return in an asset in which that return is high enough to induce the investor to surrender his\/her liquidity.<\/span><\/p>\n

Fourth principle: The risk-free rate of return is always<\/em> zero and is in accord with a state of zero action.<\/strong><\/span><\/p>\n

Inherent in the concept of a risk-free rate of return and in the context of a reward-versus-risk framework is a glaring paradox: Rewards compensate risks, so how can there be a reward for no risk, or no action as is implied by the term \u201crisk-free rate of return\u201d? Put another way, since return is the price paid to induce risk taking, why pay a return for zero risk? Therefore the risk-free rate of return does exist, and it is always zero.<\/span><\/p>\n

What we are left with then are several conclusions about the risk-free rate of return:<\/span><\/p>\n