ST Government Bonds vs LT Government Bonds (Risk free rate)

CFA Level II Equities
#1

Fama-French/Pastoral Model = ST Government Bonds are the proxy for the risk-free rate (rf)

CAPM/Macro-Economic Model (Ibbotson-Chen)/Gordon Growth Equity Risk Premium = LT Government Bonds as the proxy for the risk-free rate.

I guess just we need to memorize?

#2

Yup.

#3

@S2000magician

Hi. From a practical stand point., a ST Govt Bond should ideally be considered as the risk free rate isn’t it although practitioners look at the LT Bond. A ST or LT government bond should be considered because it has the least credit risk. But a ST Bond is more risk-free and has a lesser sensitivity to other types of risk unlike a LT Bond - like duration risk, liquidity risk, inflation risk etc. But what people are considering is only credit risk it looks like!

Looks like the only possible limitation of ST Bonds for valuation purposes would be (a) the need to readjust the yields regularly; (b) the length of the investment period/project for which a LT Bond may be preferred. But in that case we can choose the bond corresponding to the time horizon.

Any other reasons for preferring a LT Govt Bond vs a ST Govt Bond?

Thanks in advance!

#4

What does more risk-free even mean? It’s like saying dividing zero by anything gives you an improved zero.

It has to do with the FFM paper using the ST RFR in it’s emperical studies. While the CAPM papers used LT bonds. Ideally, neither are correct.

#5

By more risk free I just mean on a relative basis. To phrase it better, it is less risky than a LT bond.

#6

If it is less risky than a LT bond, then it is not risk-free either, in which case, you should refer to them as the least risky monetary security.

Anyway, all government treasuries in developed market are credit-risk free, but they carry other risks. In this case, if the other risk factors are static and exposed in the asset you’re pricing, it should not matter.

#7

Reinvestment risk is biggest risk factor with LT bonds, which is another reason why ST bonds offers lower yields. Less reinvestment risk.

This was in a vignette Topic Test, btw.

#8

That doesn’t explain the difference in zero treasury yields.