As all of the Capital Asset Pricing Model (CAPM) fans out there know, the value representing the ‘risk-free’ rate is a critical data point!
But for those who may be unfamiliar with CAPM, it’s ‘a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.’ (Source)
In finance classes professors taught that the proxy value used in the formula below for the risk-free rate of return was to be one of the short-dated U.S. treasury securities, because the U.S. government had no perceived risk of defaulting.
And, as the theory goes, the more inherent risk perceived in an investment, the more return that will be demanded by an investor.
This is why an apartment building in NYC’s Soho will be sell at an appreciably lower cap rate than the exact same building located in one of the outer boroughs of New York City.
Spread Between U.S. Treasury Bonds And Other Sovereign Debt!
So if risk-reward is the determining factor for the yield on a bond, why then is the yield spread between the 10-year German government bond and the 10-year U.S. treasury bond so wide (Germany .20% and U.S. 1.75%)?
Why then are the spreads between the yield on 10-year U.S. government debt and a wide-range of other 10-year sovereign securities negative in many cases by more than 100 basis points?
Ten year government bond spreads
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