Chapter 1The End of the Risk-Free Rate

When something is “risk free,” it is desired—for example, a free lunch, a coupon, or ticket to see a popular show. In financial markets, the economic concept of a risk-free rate is quite similar. In times of high uncertainty or distress, market participants want something that has 100 percent probability of being returned to them. The choice is typically cash or what has long been assumed as a risk-free instrument, a Treasury bill or government bond. Nothing is truly free in financial terms unless there is full back stop or subsidy of some kind. And so government bonds were viewed that way, boring instruments with a low return because they are public goods. Government bonds have been for a long time in the ...

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