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

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.