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  • This proves CAPM is wrong. 1 comment
    Aug 6, 2011 8:21 AM
    The so-called "risk free rate of return" governs the pricing of every asset on Earth. And throughout recent history, capital markets assume that this "risk free rate of return" is that of US Treasuries. And so, with Friday's downgrade of US Treasuries, standard financial asset pricing models imply that all assets - stocks, bonds, you name it - are now riskier, and prices should adjust lower to compensate investors for that extra risk.

    The problem is that this model is fundamentally flawed. US Treasuries may now be riskier, but this says nothing about whether GE is now more likely to default on its bonds, or that McDonalds is likelier to slash its dividend. If anything, with Treasuries having now been declared riskier, and thus, less appealing as investments, stocks and corporate bonds ought to rally if anything else, because the prospects for corporate issuers of stocks and bonds have are still stable, while the prospects for "risk free" assets have deterioriated.

    Whether the market will see it this way is doubtful. 
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  • Andrew Noland
    , contributor
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    Excellent overall point, and I agree with you that CAPM is wrong. It tries to approximate risk of inflation by substituting up a low-risk bond rate.

     

    But consider this alternative view to your subpoint: if the U.S. defaults on its treasury bonds, GE and McDonald's do have more credit risk because they have exposure to U.S. dollars.
    28 Dec 2011, 11:31 PM Reply Like
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