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The Risk-Free Asset Implied By the Market: Medium-Term Bonds Instead of Short-Term Bills

David Blitz
The Journal of Portfolio Management September 2020, jpm.2020.1.166; DOI: https://doi.org/10.3905/jpm.2020.1.166
David Blitz
is head of Quantitative Research at Robeco in Rotterdam, The Netherlands
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Abstract

In empirical tests of the capital asset pricing model, the theoretical risk-free asset is typically assumed to be 1-month Treasury bills. This article examines the implications of a misspecified risk-free asset—that is, the possibility that the true risk-free asset is a longer-maturity Treasury bond. A simple theoretical derivation leads to the testable prediction that low-beta (high-beta) stocks should then exhibit positive (negative) bond betas. The author finds strong empirical confirmation for these predictions. The market-implied risk-free asset can be pinpointed at medium-term (5-year) bonds. Concrete implications of this finding are a lower equity risk premium and a less steep security market line.

TOPICS: Portfolio theory, portfolio construction, derivatives

Key Findings

  • • In empirical tests of the capital asset pricing model, the theoretical risk-free asset is typically assumed to be 1-month Treasury bills. This article examines the implications of a misspecified risk-free asset—that is, the possibility that the true risk-free asset is a longer-maturity Treasury bond.

  • • A simple theoretical derivation leads to the testable prediction that low-beta (high-beta) stocks should then exhibit positive (negative) bond betas.

  • • The author finds strong empirical confirmation for these predictions and can pinpoint the market-implied risk-free asset at medium-term (5-year) bonds. Concrete implications of this finding are a lower equity risk premium and a less steep security market line.

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The Journal of Portfolio Management: 48 (8)
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The Risk-Free Asset Implied By the Market: Medium-Term Bonds Instead of Short-Term Bills
David Blitz
The Journal of Portfolio Management Jul 2020, jpm.2020.1.166; DOI: 10.3905/jpm.2020.1.166

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The Risk-Free Asset Implied By the Market: Medium-Term Bonds Instead of Short-Term Bills
David Blitz
The Journal of Portfolio Management Jul 2020, jpm.2020.1.166; DOI: 10.3905/jpm.2020.1.166
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