Is it possible to use a bond index as a proxy for Rf in CAPM? Please let me know what is the issue here.
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2 Answers
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Bond index is a composition of government bonds, municipal bonds, corporate bonds, high-yield bonds, mortgage-backed securities, syndicated or leveraged loans, etc. Whereas Rf is risk free rate is typically equal to the yield on a 10-year US government bond,which is essentially risk free unlike bond index. Using bond index would not lead to an accurate CAPM.
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$\begingroup$ Thank you for the answer. If I use Thomson "Reuters Eurozone 10 Years Government Benchmark" or Euro MTX 7-10 Y, I think is better than 10Y German bond. The bond Index represents the average returns that the average investor can earn. The "problem" is that I have not find any paper to follow this approach. $\endgroup$– sotnikSep 27, 2018 at 11:37
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$\begingroup$ @sornik That’s because such an index is not risk free and thus a bad proxy for the risk free rate. $\endgroup$– Bob Jansen ♦Oct 28, 2018 at 21:05
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It depends on how you define the risk-free rate and you should be able to show persuading reasons once you choose a rate to be risk-free , whatever Libor rate or Treasury rate or others. I remember in CAPM, the risk-free rate also represents the rate at which an investor can lend or borrow money without committing losses to build an efficient portfolio, so this rate should in theory be not volatile, a bond index would not fit this requirement I think.
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$\begingroup$ That's absolutely correct only if all investors lend or borrow money using the same financial instrument. In reality, they use instruments with different duration's and different risks (i.e they can use France, Germany, Italy bonds of various maturities). Seems to be that the bond index has the advantage that represent the average risk free return. The increased volatility is a serious issue that has to be justified. $\endgroup$– sotnikSep 28, 2018 at 22:15