Our Research posts are about the latest academic research being done in the School of Economics. This week:
The eminence of risk-free rates in portfolio management: A South African perspective
by Prof Chris van Heerden
The traditional Capital Asset Pricing Model (CAPM) suggests that the minimum return required by an investor should be equal to the return of a risk-free asset (Reilly & Brown, 2003), which should be stable (Reilly & Brown, 2006), not influenced by external factors (Harrington, 1987), and certain (Bodie, Kane & Marcus, 2010). Evidence, however, suggests that risk-free asset returns vary (Brunnermeier, 2008), and that “there is really no such thing as a truly riskless asset” (Brigham & Ehrhardt, 2005:312). The pioneering studies of Mehra and Prescott (1985) and Weil (1989) only justified the size of the equity premium and risk-free rate puzzle but failed to provide a consensus on the specifications for the most ideal risk-free rate proxies. The results from this paper accentuated the problem of selecting a risk-free rate proxy, as all proxies under evaluation exhibited a level of risk and volatile returns. No regularities between the pre-, during and post-financial crisis regarding the choice of most ideal risk-free rate proxy were found. Overall findings suggested that the ideal proxies are the 3-month T-Bill rate and the 3-month NCD rate for the pre-, during and post-financial crisis periods, respectively.
This paper is forthcoming in the Journal of Applied Business Research, March / April 2016.