Friday, July 29, 2011

A Treasury Downgrade and the Risk Free Rate

Great minds and all that. On Tuesday I dropped a comment at MarketBeat:
Dear Mr. Gongloff, When writing algorithms requiring a risk-free rate e.g. an old-fashioned Black-Scholes model or a Sharpe ratio, is it possible to substitute something for short dated T-bills?
I’m thinking of using Δy of Apple common.

Today FT Alphaville posts:

In a brave new world, there are no benchmarks
UK retailer John Lewis proudly boasts that it has never been knowingly undersold in the market. Its retail prices, consequently, can be used by consumers as a benchmark to compare all other retail prices against (yes, we know, the mantra doesn’t apply to their website prices, but you see our point.)

So, applying the same philosophy to financial markets, you could say, the US is the global markets’ version of John Lewis. Its securities provide the prices against which all other securities in the world are priced.

Default or no default, the real crisis that is likely to befall us then — irrespective of what debt deal is finally done — is the real and very sudden loss of the world’s single most important pricing benchmark....

...Anyone who believes a downgrade won’t be much of an issue because the world will collectively lower its standards to a AA reality, is therefore potentially missing the point.

The key issue is that a downgrade spells the death of “risk-free“.  Without a veritable “risk-free” rate, it’s a brave new world in finance, where all prices suddenly become meaningless....MUCH MORE between the ellipses.