However, setting [gamma] to a very large number also has implications for the risk-free rate
that do not fit the data.
13) The lucrum cessans is the real risk-free rate
To control for the fragmentation in the risk-free rate
and bank funding costs, we regress the country time dummies on sovereign bond yields.
For one, these economists say that the government is able to finance its projects by borrowing at a risk-free rate
and that this justifies not incorporating a risk premium in the discount rate because the risk does not appear in the government's cost of financing.
It turns out that in most economic models, the two key economic considerations--the risk-free rate
used for discounting expected damages and the size of the risk premium--are connected.
Assume that the spot risk-free rate
, r, in a frictionless market follows a mean-reverting diffusion process
The capital asset pricing model (CAPM) implies that x should equal the risk-free rate
plus a term related to the covariance of the cash flow with the market, that is, x = [r.
Risk-averse investors would always prefer the portfolio possibility line with the highest slope since this would maximize an investor's return in excess of the risk-free rate
for every unit of market risk.
The key point here is that because systemic risk is a product of market imperfections, the financial risk it creates is both a component of the risk premium and the risk-free rate
Finally, any forecast error in the equity-premium rate pales in comparison with the failure of standard options, which incorporate no shareholder opportunity cost, not even the risk-free rate
on Treasury securities.
The discount rate is made up of two components, the risk-free rate
(to compensate for the time value of money] and the risk rate (to compensate for the uncertainty of the expected future cash flows].
Other critics object to the use of an investment-based discount rate in any circumstances, arguing instead for the use of a risk-free rate
of return (e.