Risk-Free Rate Puzzle (RFRP)

What Is the Risk-Free Rate Puzzle (RFRP)?

The risk-free rate puzzle (RFRP) is a market anomaly saw in the relentless difference between the lower historic real returns of government bonds compared to equities. This puzzle is the inverse of the equity premium puzzle and takes a gander at the disparity according to the point of view of the lower returning government bonds. It basically inquires: for what reason is the risk-free rate or return so low assuming that agents are so averse to intertemporal substitution?

Key Takeaways

• The risk-free rate puzzle alludes to the gap between returns on stocks compared to government bonds.
• Economists Edward Prescott and Rajnish Mehra in a 1985 paper that point out that the difference in returns couldn't be made sense of by then current economic models.
• A few clarifications of the riddle have been advanced by different economists in the years since, many zeroing in on the most proficient method to model investor preferences and a nature of risk.

Understanding the Risk-Free Rate Puzzle (RFRP)

The risk-free rate puzzle is utilized to make sense of why bond returns are lower than equity returns by checking out at investor preference. Assuming investors will quite often search out high returns, for what reason do they additionally invest so vigorously in government bonds as opposed to in equities?

In the event that investors put resources into additional equities, returns from equities would fall, causing the relative returns for government bonds to rise and making the equity premium more modest. In this way, we have two interrelated puzzles in light of long-run empirical perception of market prices: the equity premium riddle (for what reason is the equity risk premium so high?) and the risk-free rate puzzle (why the risk-free rate so low?).

Scholastic work in the field of economics has looked for a really long time to determine these riddles, yet a consensus actually has not been arrived at on why these oddities endure. Economists Rajnish Mehra of Columbia University and Edward Prescott of the Federal Reserve (1985) investigated U.S. market data from 1889 to 1978 and found that the average annual premium of equity returns over the risk-free rate was around 7%, which is too large to be justified by the standard economic model given a reasonable degree of risk aversion.

As such, stocks are not adequately more risky than Treasury bills to make sense of the spread (difference) in their returns.

Mehra and Prescott also point out that the real interest rate saw over a similar period was just 0.8%, which was too low to be made sense of in their model. In 1989, Harvard economist Philippe Weil contended that the low interest rate was a riddle since it couldn't be justified by a representative agent model with a conceivable degree of risk aversion and an erratic level of between fleeting elasticity of substitution.

Answers for the Puzzle

A few conceivable answers for the risk-free rate puzzle have been advanced by different economists. These contentions largely center around the idea of the risks presented by equities versus Treasury securities and their relationship on individuals' income and consumption over the long haul. They differently make sense of the risk-free rate puzzle in terms of various suppositions about preferences (compared to Prescott and Mehra's model), the likelihood of rare yet tragic occasions, survival bias, and deficient or imperfect markets. Others have pointed to empirical evidence that the risk-free rate puzzle is more articulated in the U.S. furthermore, less so when data from world markets are thought of, which may be made sense of by the U.S's. historically predominant position in the global economy.

Maybe one of the most grounded lines of reasoning is that the fat-followed likelihood distribution of equity returns is at play. Rare however extreme negative returns across equity markets are known to occur, yet troublesome or difficult to unequivocally anticipate. Rare occasions like world conflicts, sorrows, and pandemics can make such negative economic shocks, affecting equity returns specifically, that investors demand a higher average return on them, perhaps making sense of the risk-free rate puzzle. Investors build their appraisals of dubious future economic growth around an unchangeably fat-followed distribution of negative shocks (and in this manner equity returns). This contention was initially developed by economist Thomas Rietz and later elaborated separately by economists Robert Barro and Martin Weitzman.