No thing is risk free

No thing is risk free - 1 Into the Abyss: What if nothing...

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Unformatted text preview: 1 Into the Abyss: What if nothing is risk free? July 2010 Aswath Damodaran Stern School of Business adamodar@stern.nyu.edu 2 Into the Abyss: What if nothing is risk free? In corporate finance and investment analysis, we assume that there is an investment with a guaranteed return that offers both firms and investors a risk free choice. This assumption, innocuous though it may seem, is a critical component of both risk and return models and corporate financial theory. But what if there is no risk free investment? During the banking crisis of 2008, this question came to the fore, as investors began questioning the credit worthiness of US treasuries, UK gilts and Germans bonds. In effect, the fear that governments can default, hitherto restricted to risky, emerging markets, had seeped into developed markets as well. In this paper, we examine why governments may default, even on local currency bonds, and the consequences. We also look at how best to estimate a risk free rate, when no default free entity exists, and the effects on both investors and firms. In particular, we argue that the absence of a riskfree investment will make investors collectively more risk averse, thus reducing the prices of all risky assets, and induce firms to borrow less money and pay out lower dividends. 3 If there is a constant in any financial analysis, it is that there is at least one entity that is incapable of default and that investing in its financial obligations yields a guaranteed return; this guaranteed return represents a risk free rate and it is the base on which we build expected returns for risky assets. That default free entity is usually the government, with the implicit assumptions being both that the cost of default is so catastrophic that governments will find a way to fulfill their obligations and that they have more powers to do so, including the right to print money, than other entities. When governments default or are perceived as capable of default, their obligations are no longer guaranteed, and this has profound implications both for financial analysis and decision- making. In this paper, we begin by first defining a risk free rate and then examining why the risk free investment is so central to financial theory and investing practice. We then look at the history of sovereign defaults and the circumstances that precipitated these defaults. We move on to ways of estimating the default risk in sovereign investments, from sovereign ratings to market prices. In the final section, we look at ways of dealing with the possibility that governments can default and the consequences for corporate finance and investing. What is a risk free investment? To understand what makes an investment risk free, let us go back to how risk is measured in finance. Investors who invest in an asset 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...
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No thing is risk free - 1 Into the Abyss: What if nothing...

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