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so this afternoon I was perusing through a finance book from college and came cross a chapter on the capital asset pricing model (CAPM). Theory states the risk free rate is that of the 10-yr. treasury. Is this really risk free now? Do we need to rewrite the text books? I say YA... **** DC and NYC:mad:
 

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The Convicted Audiophile™
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so this afternoon I was perusing through a finance book from college and came cross a chapter on the capital asset pricing model (CAPM). Theory states the risk free rate is that of the 10-yr. treasury. Do we need to rewrite the text books? I say YA... **** DC and NYC:mad:
You can use what ever you want for the "risk free rate"
I consider the S&P 500 my risk free rate
You could use the 3 month CD rate at your bank if you want
What ever YOU feel is THE risk free rate

Is this really risk free now?
Depends who you ask....;)
 

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It's risk free in the sense that you will receive "something" from the FedGov when it the bond is due.

Exactly what that "something" is remains to be seen.

Jack
 

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so this afternoon I was perusing through a finance book from college and came cross a chapter on the capital asset pricing model (CAPM). Theory states the risk free rate is that of the 10-yr. treasury. Is this really risk free now? Do we need to rewrite the text books? I say YA... **** DC and NYC:mad:
I think they were referring to market risk. Bonds have default risk, dilution risk and inflation risk.
 

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Sun, the risk free rate is considered, by the finance community, to be, in essence, "free" of those risks you quoted, or at least the "most free" asset out of every other asset class. Even a casual reader can immediately understand why this is nonsense and today's situation we all find ourselves in is a perfect example of the alchemy that is modern finance. It's literal linear thinking rubbish... the backdoor for all of these idiot calculations has always been the currency. The US Government can "not" default ever in the true sense, but print so many USD's to pay off all the debt that the USD's they send you for the bond are essentially worthless. No default though... It's just junk. This entire global financial system is collapsing on itself in a giant debt/greed/hubris supernova.
 

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As long as inflation exists, risk-free rate will essentially be negative in theory, and nonexistent in practice. Even money in a safe or mattress is at risk of loss or destruction.

That said, the "risk-free" part is meant to be taken in stride, not as an absolute. What risk-free rate really refers to is the rate of return on whatever investment is least risky during a given time period. It's usually short-term government bonds, but that's not etched in stone or anything. It's still a useful concept, as long as you actually understand what it means instead of taking it at face value.

I know there's a lot of anti-economist sentiment on this board, but remember that the ones you see on the MSM are not the only economists out there. Plenty of financial men and women actually know their stuff. It isn't their fault that TV deems them too boring.
 

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Sun, the risk free rate is considered, by the finance community, to be, in essence, "free" of those risks you quoted, or at least the "most free" asset out of every other asset class. Even a casual reader can immediately understand why this is nonsense and today's situation we all find ourselves in is a perfect example of the alchemy that is modern finance. It's literal linear thinking rubbish... the backdoor for all of these idiot calculations has always been the currency. The US Government can "not" default ever in the true sense, but print so many USD's to pay off all the debt that the USD's they send you for the bond are essentially worthless. No default though... It's just junk. This entire global financial system is collapsing on itself in a giant debt/greed/hubris supernova.
Not really, the risk-free rate is free from market risk. The Yield-to-maturity is what you are expected to get, unless there is a default.

No security is truly risk free.

A corporate bond could be rendered useless if that company goes bankrupt.
A US government bond will always have the principle and yield intact, due to the FED's ability to print new money to meet the obligation.

The assumption is that the amount of printing will be minimal compared to the total debt load, GNP and GDP.

In recent times, that assumption is erroneous as those at the helm, either doesn't know what is happening, or is inflating the money supply on purpose. Regardless, the result is the same, destruction of the purchasing power of the US dollar.
 

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so this afternoon I was perusing through a finance book from college and came cross a chapter on the capital asset pricing model (CAPM). Theory states the risk free rate is that of the 10-yr. treasury. Is this really risk free now? Do we need to rewrite the text books? I say YA... **** DC and NYC:mad:
CAPM is used to determine the desirable rate of return for a given stock when compared to the riskfree asset (something with a fixed rate, no default) vs. a market risk asset (the market as a whole, with a floating rate of return, and default risk, mitigated through diversification).

This generates a coefficient called a BETA which is the rate of deviation relative to the entire market.

The beta is a function of the proxy. So if your set your beta to 1.5 against the NASDAQ, then for every 1% move in the NASDAQ you should expect a 1.5% move in your stock.

CAPM is built on top of inflation concerns. Thus if your risk free asset is yielding 0.25% and market risk is yielding 15%, when inflation is 10%, then:

Bonds are yielding a "real" rate of -9.75% (before transaction costs)
Stocks are yielding a "real" rate of 5% (before transaction costs)

When commodities are yielding 60-125% during the same time frame, and unsound fiscal and monetary policies persists, then Stocks and Bonds are should yield to the investment of commodities.

So you see, the risk-free asset is intact in the CAPM model.

Infact, CAPM is telling you to buy commodities because the Riskfree (Treasuries) and the Market risk (S&P 500) are both yielding less in real terms.

Here endth the lesson.
 

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I've always seen it just as a reference point with no intrinsic meaning beyond that. The zero point on a rubber ruler.
CAPM works, as long as you preface it with other criteria. Alone, its not enough to account for the global currency instability.

If you select companies that make money directly from the government, essentially you have companies that have no default risk and only inflation risk, and currency translation risk.

Investing in the markets is no longer for the neophyte day-trader. You have to know what you are doing, or you are going to get burned.
 

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Not really, the risk-free rate is free from market risk. The Yield-to-maturity is what you are expected to get, unless there is a default.

No security is truly risk free.

A corporate bond could be rendered useless if that company goes bankrupt.
A US government bond will always have the principle and yield intact, due to the FED's ability to print new money to meet the obligation.

The assumption is that the amount of printing will be minimal compared to the total debt load, GNP and GDP.

In recent times, that assumption is erroneous as those at the helm, either doesn't know what is happening, or is inflating the money supply on purpose. Regardless, the result is the same, destruction of the purchasing power of the US dollar.
"Not really" what? Your second sentence backs up what I wrote and what you have dubbed, "Not really". No security is "risk free". The finance community knows this. It is not just a default risk that you consider when you look for a risk free asset, but also interest rate risk, currency risk, liquidity risk, and so on. Even the T-Bills share at least the currency risk since they have always suffered from dilution of the USD. This is why I've stated that MPT and CAPM are rubbish.

CAPM is useless for a number of reasons, one of which is the notion of the risk free rate and the notion of "beta" and "alpha". But at the heart of all the noise is the Eff. Market Hyp. and the fact that it is also rubbish. Calcs like these harp on relative performance which is the poorly performing hedge fund manager's best friend. It's crap.

M&M, Markowitz, Fama, Sharpe, et all live in a fantasy world which has produced calc's that do not square out in the real world. There is little to no evidence that CAPM does anything useful other than provide for a nice semester of talking points for a lazy professor. Half of the equation runs off of the notion of beta, which is NOT a measure of risk, it is a measure of variability in pricing.
 

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CAPM works, as long as you preface it with other criteria. Alone, its not enough to account for the global currency instability.

If you select companies that make money directly from the government, essentially you have companies that have no default risk and only inflation risk, and currency translation risk.

Investing in the markets is no longer for the neophyte day-trader. You have to know what you are doing, or you are going to get burned.
I do not understand how CAPM could work when there are entire decades plus in the market where high beta stocks underperformed low beta stocks essentially saying that investors were not compensated with return for taking on more risk.

Also, what do you mean when you say that a company that makes money directly from the government has no "default" risk? Any company can go bankrupt, which means that, if it had debt/bonds, it would "default". Stocks do not "default", they just go to $0. So I am not sure what you mean here.
 

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I do not understand how CAPM could work when there are entire decades plus in the market where high beta stocks underperformed low beta stocks essentially saying that investors were not compensated with return for taking on more risk.

Also, what do you mean when you say that a company that makes money directly from the government has no "default" risk? Any company can go bankrupt, which means that, if it had debt/bonds, it would "default". Stocks do not "default", they just go to $0. So I am not sure what you mean here.
High beta just mean high risk. Low beta stocks are steadier.

JPMorgan and Citibank are good examples are a government supported company. They can get liquidity whenever they request it. Their stock may fall, but they will be propped up by the government like a kick stand.

Boeing and Lockheed Martin also receives most of its income from defense contracting, thus money is printed to be handed over to it. The likelihood of these companies going bankrupt are remote at best.
 

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High beta just mean high risk. Low beta stocks are steadier.

JPMorgan and Citibank are good examples are a government supported company. They can get liquidity whenever they request it. Their stock may fall, but they will be propped up by the government like a kick stand.

Boeing and Lockheed Martin also receives most of its income from defense contracting, thus money is printed to be handed over to it. The likelihood of these companies going bankrupt are remote at best.
High beta does not mean high risk. Beta is a relationship term but the relationship is pricing, not risk.

Was Wells a government supported company? I guess, until it wasn't. How about Wachovia?

How about General Motors? How did that government supported company fare? Chrysler (wasn't public)?

Yes, there are some "too big to fail" institutions which have been knighted by those in power... until they are not. But even still, that does not guarantee the solvency of the firm. I agree though, it sure helps.
 

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High beta does not mean high risk. Beta is a relationship term but the relationship is pricing, not risk.

Was Wells a government supported company? I guess, until it wasn't. How about Wachovia?

How about General Motors? How did that government supported company fare? Chrysler (wasn't public)?

Yes, there are some "too big to fail" institutions which have been knighted by those in power... until they are not. But even still, that does not guarantee the solvency of the firm. I agree though, it sure helps.
Risk = Volatility in pricing. Beta is a measure of volatility. A beta of 1 is equal to the market risk proxy in CAPM.

The market risk proxy represents the market with full diversification thus mitigating all non-systematic risk, the lowest level of market risk. Thus a high beta = high risk relative to the market risk proxy and the risk free asset.

There is a whole class on this subject. The problem lies in the naming conventions as they are a bit misleading if taken out of context of the CAPM model.

You can read about it here:
http://en.wikipedia.org/wiki/CAPM

The companies you mentioned do not have a dedicated revenue inflow through government contracts.

Look for companies that sell directly to the government, instead of just receiving subsidies.

While there is no guarantee that these companies cannot fail, it is more likely that they survive, even through a dollar collapse as they are an integral part of the continuity of government agenda. However, there does exist a possibility of nationalization of these companies that would render ownership of these stocks void.

I like physical metals better, but there is no positive cashflow stream associated with them, unless you lend them out at a fee..
 

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Sun, beta does not mean risk. If I asked you to give me the beta of XOM using the Dow 30 you would tell me 1.12 or whatever it is. If I then asked you what the probability of loss is of my XOM investment is, are you again going to tell me the beta? No. Beta describes the pricing relationship, or magnitude of the move of some asset relative to another. But it does not tell you anything about the risk of that asset, only how it will move when compared to something else.
 

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Sun, beta does not mean risk. If I asked you to give me the beta of XOM using the Dow 30 you would tell me 1.12 or whatever it is. If I then asked you what the probability of loss is of my XOM investment is, are you again going to tell me the beta? No. Beta describes the pricing relationship, or magnitude of the move of some asset relative to another. But it does not tell you anything about the risk of that asset, only how it will move when compared to something else.
The beta is the deviation of a particular stock when compared to the market average value, usually designated by proxy depending on focus (DOW 30, DOW Transports, S&P 500, NASDAQ, etc).

The deviation from the (diversified) market risk = systematic risk.

What it doesn't tell you is the probability of occurrence, only the magnitude of deviation.
 
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