Risk-Free Rates and Benchmarks
Understanding what 'risk-free' really means, how government bonds serve as benchmarks, and the role of OIS in modern markets
In finance, the risk-free rate (RFR) is the theoretical rate of return on an investment with zero risk of financial loss. It serves as the baseline for valuing all other investments—everything else is priced as "risk-free rate plus a risk premium."
As we discussed in Chapter 1.6, the JGB yield curve serves as the foundation for pricing nearly all Japanese financial assets. This is because JGB yields are treated as the baseline rate, better known as the risk-free rate. This chapter focuses on a more technical question: What exactly is "risk-free," and are JGBs truly the best measure?
Government Bonds as the Traditional RFR
Historically, government bond yields have been used as the practical proxy for risk-free rates. In Japan, the 10-year JGB yield is the standard benchmark. In the US, it's the 10-year Treasury yield.
Why government bonds?
- No Credit Risk: Governments that issue debt in their own currency (Japan, US, UK) can always print money to repay debt. Default risk is 'effectively' zero.
- High Liquidity: Government bond markets are deep and liquid, with continuous pricing and tight bid-ask spreads.
- Market Acceptance: Decades of practice have established government yields as the universal benchmark across asset classes.
But Are They Truly "Risk-Free"?
The term "risk-free" is actually a misnomer and can be confusing. Government bonds may be considereed free of credit/default risk by traditional standards (that only hold under certain conditions), but they are not free of all risk and certainly not by modern standards:
| Risk Type | Description |
|---|---|
| Interest Rate Risk | If market yields rise, your bond's price will fall (mark-to-market loss). Even though you'll get par at maturity, the interim price volatility is real risk. |
| Inflation Risk | If inflation is 3% and your bond yields 1%, you are losing purchasing power in real terms. Your nominal return is positive, but your real return is negative. |
| Term Premium | Longer-term bonds yield more than short-term bonds not just because of expected rate changes, but because investors demand compensation for the uncertainty and liquidity risk of locking up capital for longer periods. |
| Sovereign Risk Premium | Even in developed markets, there is a risk premium reflecting fiscal sustainability concerns. Japan's gross debt-to-GDP ratio of 192-264% (depending on methodology; MOF figures ~215%, IMF estimates ~240-260%) means JGBs trade with a slightly higher yield than theoretical "pure" risk-free rates. |
The Bottom Line: When finance textbooks say "risk-free rate," they mean credit-risk-free when sovereign risk is low. All other risks (interest rate, inflation, term, liquidity) remain and are actively priced in.
Modern Alternative: OIS (Overnight Index Swap) Rates
In recent years, professional markets have increasingly adopted OIS rates as a more accurate measure of the true risk-free rate, particularly for derivative pricing and interbank lending.
What is OIS?
An Overnight Index Swap (OIS) is a derivative contract where one party pays a fixed rate and receives a floating rate based on the average of overnight policy rates (in Japan, this is the BOJ's policy rate; in the US, it's the Fed Funds rate).
Why is OIS considered more "risk-free" than government bonds?
- No Term Premium: OIS reflects the market's expectation of the average overnight rate over the swap's term. It strips out the term premium embedded in government bond yields.
- No Fiscal Risk: Unlike government bonds, OIS rates don't reflect concerns about sovereign debt sustainability.
- Pure Policy Rate Expectations: OIS rates are the cleanest measure of what market participants expect central banks to do with short-term rates.
When to Use OIS vs. Government Bonds
| Use Case | Preferred Benchmark | Reason |
|---|---|---|
| Derivative Pricing | OIS | Derivatives desks need the purest measure of funding costs, free of term and fiscal premiums. |
| Interbank Lending | OIS | Banks lend to each other at rates benchmarked to OIS, not government bonds. |
| Corporate Bond Valuation | Government Bonds | Corporate bonds are priced as: Government Yield + Credit Spread. This convention is deeply embedded in markets. |
| Long-term Investment Hurdle Rates | Government Bonds | Pension funds and insurers use government yields as the opportunity cost for long-term capital allocation. |
| Academic Models (CAPM, DCF) | Government Bonds (traditionally) | Most textbooks and models still use government yields, though this is slowly shifting toward OIS in professional practice. |
Practical Takeaway
As a rates trader or analyst, you need to understand both benchmarks:
- JGB yields are the reference for corporate bonds, asset allocation, and public market sentiment.
- OIS rates are the reference for derivatives, interbank funding, and pure policy rate expectations.
When someone says "risk-free rate" in Japan, they usually mean the 10-year JGB yield—but context matters. In a derivatives context, they might mean 10-year JPY OIS. Always clarify which benchmark is being used.
References
- Bank for International Settlements. "Risk-free interest rates: measurement and issues." BIS Quarterly Review. Available at: https://www.bis.org/publ/qtrpdf/r_qt1803h.htm.
- Japan Ministry of Finance. "JGB Interest Rate Data." Available at: https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm.