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This a fantastic question. So a good example of a risk free asset is a T-Bill. What type of derivative instruments are you referring to?
Thanks for reply! Im writing a thesis on whether risk-free assets are really risk-free. And then what the effect would be on the pricing of derivative instruments- futures or options. They both discount or compound at the risk-free rate. Like futures compounds the spot price at the risk-free rate to get to the futures price. risk-free rates that aren`t really risk-free can lead to miss pricing and then arbitragers will exploit the situation. I`m struggling to find good references on this topic. All research a can find simply takes the risk-free rate as a given..
the article of Aswath Damodaran on "What is the risk-free rate?" is the closest i get to anything relating to my topic.
We defined a riskfree asset as one where the investor knows the expected return with certainty. Consequently, for an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met –
• There has to be no default risk, which generally implies that the security has to be issued by a government. Note, though, that not all governments are default free and the presence of government or sovereign default risk can make it very difficult to estimate riskfree rates in some currencies.
• There can be no uncertainty about reinvestment rates, which implies that there are non intermediate cash flows. To illustrate this point, assume that you are trying to estimate the expected return over a five-year period and that you want a risk free rate.A six-month treasury bill rate, while default free, will not be risk free, because there is the reinvestment risk of not knowing what the treasury bill rate will be in six months. Even a 5-year treasury bond is not risk free, since the coupons on the bond will be reinvested at rates that cannot be predicted today. The risk-free rate for a fiveyear time horizon has to be the expected return on a default-free (government) fiveyear zero coupon bond.
As a practical compromise, however, the logical consequence for valuations, where cash flows stretch out over long periods (or to infinity), is that the risk free rates used should almost always be long-term rates. In most currencies, there is usually a 10-year government bond rate that offers a reasonable measure of the riskfree rate.
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Arno, you said you are writing a thesis. You have to do some research and analysis of your own. Do not just rehash the material from Damodaran and other authors.
that is exactly my problem. I'm looking for authors that write on the risk free rate. I have read most of what Damodaran says on the risk free rate. He is the only author that i can find that writes extensively on the issue. Damoaran explains it really well, but i can`t rely on one author only. I`m doing a study on South African risk free assets. For introduction i need to write about the risk free asset, and how risk free they really are. The research part of my thesis is on the "risk free" assets used in South Africa for pricing and valuation. Thanks for all the replies- much appreciated! If u know of any other authors that write on this subject please let me know. Thanks