Download this Paper Open PDF in Browser

Into the Abyss: What If Nothing is Risk Free?

55 Pages Posted: 24 Jul 2010  

Aswath Damodaran

New York University - Stern School of Business

Date Written: July 23, 2010

Abstract

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 German 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 risk free 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.

Keywords: Risk Free Rate, Government Default, Sovereign Risk

JEL Classification: G11, G12

Suggested Citation

Damodaran, Aswath, Into the Abyss: What If Nothing is Risk Free? (July 23, 2010). Available at SSRN: https://ssrn.com/abstract=1648164 or http://dx.doi.org/10.2139/ssrn.1648164

Aswath Damodaran (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0340 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.damodaran.com

Paper statistics

Downloads
4,288
Rank
1,484
Abstract Views
14,590