What is the risk free rate?

[woody]

I'm wondering how people are calculating the risk free rate now.

 

[charlesdwright]

I'm wondering how/why LIBOR became the benchmark to begin with.

 

[Sanket Patel]

I'm wondering how/why LIBOR became the benchmark to begin with.

I remember reading sometime ago that one of the reason LIBOR is used is because many institutions are required to hold US gov't debt to fulfill regulatory requirements. This effectively (and somewhat artificially) drives up demand and yields down. Thus, even though, the US gov't debt is risk-free, the yields are artificially low. And unless I'm mistaken, I believe US gov't debt receives favorable tax treatment, at least at the state level, which is once again likely to increase demand and drive down yields.

Whatever the specifics are, my understanding is that the yields on U.S Treasuries are "artificially low." I'll see if I dig up just where exactly I ran across this.

 

[Stefan Zota]

Your responses follow the statements from Hull's book.

 

[Sanket Patel]

Thank you! That's been bugging me all morning.

 

[charlesdwright]

Yes, that does sound very familiar. Thank you.

I don't wholeheartedly agree with the arbitrary conclusion, but I am also not quite up to arguing an alternative.

...except for the empirically obvious one: It would have been better, thus far, had the other arbitrary, less "artificial" benchmark not been chosen.

OK, here's my argument: the safe haven ought to be the "risk free asset;" although I'm sure someone will argue that's subjective. Perhaps. But it's less subjective.

 

[bob]

Even LIBOR isn't a great measure of the real funding rates at the short end, for reasons discussed in another thread.

Over here we use Reuters df's for this purpose. Pretty much everyone uses futures for the middle of the curve and par swap rates at the end. Reuters uses both LIBOR and quoted short-term deposit rates at the short end. In the current environment, this makes the Reuters curves much more volatile there, and the rates are generally higher than LIBOR.

It makes sense to use these since what matters for hedging, risk, capital allocation and so on is the rate at which *you* can fund, rather than the rate at which, say, Treasury or Goldman Sachs can.

...And this raises a whole series of issues, since the rate at which you can fund and the risk-free yield you can get in the market are undoubtedly not the same. So even an instrument as simple as a forward contract gets more complicated: For you, the spread in rates means that there's a long forward price and a short forward price, and the two aren't the same. Following this through to put-call parity and dynamic hedging arguments, this means there's one forward for you for long call / short put positions, and a different one for short call / long put positions....

 

[charlesdwright]

According to this article Libor Holds Central Banks Hostage as Credit Freezes - QuantNetwork - Financial Engineering Forum , the current risk-free-rate is "I don't know."