2012-06-21 – London
Risk free assets underpin widely used financial theory
Within the insurance, investment and banking industries, all of the most widely used financial theories require the existence of risk-free assets. Risk-free assets form the basis upon which the valuation of all other assets are calculated, because the theoretical assumptions in the underlying mathematical theories used to construct yields, discount rates, risk premiums and spreads all depend on their existence. In addition, financial regulators seem to consider risk-free assets as a useful reference when specifying capital requirements and asset allocation rules.
Traditionally, government debt issued by the USA, the UK, Germany and Japan have been used as risk-free assets within their respective economies. However, this principle, which has been seen as unquestionable until recently, should now be revisited as a result of several developments over the last few years.
Firstly, nominal and real debt-issues have been used interchangeably as central banks have controlled inflation diligently and effectively during the last few decades. However, future inflation evolution is very unpredictable as central banks in western economies have been implementing very aggressive non-orthodox monetary policies. Consequently, going forward nominal rates might not be considered risk-free due to this embedded inflation risk.
Secondly, developed economies have dramatically increased their sovereign debt in the last few years, mainly due to very high government spending. In addition, there is a great deal of uncertainty surrounding the unfunded and off-balance sheet liabilities of these governments. Credit default swaps (CDS) and most medium and long term sovereign debt issues of certain developed economies, most notably the peripheral European economies, are trading at historically high yields. In addition, the effects of globalisation have been to increase the correlation between these economies, and as such, sovereign debt issues do not reflect the levels of diversification required to be considered as risk-free assets.
Thirdly, supranational sovereign debt is growing as a relatively new asset class. The Word Bank, the IMF and regional multilateral banks have traditionally been the main issuers. These issuers have higher diversification benefits, compared to smaller governments, but their liquidity is very limited. Recently, the European Financial Stabilisation Mechanism, which will be replaced shortly by the European Stability Mechanism, has also started to issue supranational sovereign debt backed by the governments of the Euro area. In addition, the issuance of so-called Eurobonds may soon be approved, however the ECB does not currently have a mandate to issue such bonds, and certain governments, most notably that of Germany, have indicated fierce opposition to the issuing of Eurobonds.
Lastly, senior debt-issues of some multinational corporations are trading at lower yields than many sovereigns. These corporations have clearer liability structures, and higher geographic diversification. Additionally, credit risk in many industries is seen as uncorrelated with economic growth and the liquidity of these corporate debt issues is growing. However, regulatory and tax issues will continue to affect the usefulness of multinational corporate debt as risk-free instruments and corporations do not issue inflation-linked debt, at least not in any useful volumes.
In summary, the risk embedded within so-called risk-free assets may soon become too large to ignore as simply theoretical inconveniences. This may have considerable impact on the so-called efficient frontier, if such an “efficient” frontier does exist, which will impact greatly on market volatility and macro-economic stability. In our opinion, academics, regulators and practitioners cannot ignore this situation for much longer, and significant efforts have to be deployed to solve this growing and important source of uncertainty.
