This is pretty complex topic and admittedly an unlikely hypothetical. What would be the implications on Modern Portfolio Theory if the US defaulted on their debt? (Again, unlikely, but an interesting topic) What would be the next ‘risk-free’ asset in line? I believe that MPT would be less applicable without a risk-free asset as a portfolio would no longer be able to reach outside the efficient frontier to generate that optimal risky portoflio. How useful is MPT without the US Treasuries as a baseline? Thoughts? Opinions?
MPT will still hold because in the absence of risk free asset, then the zero beta portfolio will apply.
they’re not going to default. there’s plenty to repay principal/interest on bonds, social security, etc. if anything, smaller entitlement programs would get chopped. still not a good situation, but far from default. not in the cards.
can rf be 0?
If you read the original post, you would note that I mentioned twice that a US default was unlikely at best. I have very little interest in politics and do not want to start a thread regarding cutting entitlements or raising taxes. I’m merely bringing up the topic from a theoretical and academic stand point on modern portfolio theory without a risk free asset.
Even if the default doesn’t happen, the loss of AAA rating will have interesting effects on portfolio analysis.
Australia had to the opposite problem about a decade ago. That is, due to several years of surplus the gov’t was considering whether the country needed the tsry bond market at all. The potential consequences for financial markets (i.e. lack of a tsry benchmark) are, I suppose, similar. Not surprisingly, the review found that the gov’t should continue to issue bonds even if it didn’t need to. It’s pretty scary that people are even suggesting a possibility of a US default… Interesting times.
The next “safe haven” in line is the yen if there is a US default. There is a spike in Yen and swiss franc purchases on expectation of US default. The swiss franc has consitently appreciated against the Euro and the USD
This reveals how dumb the “animal spirits” are. So the US may do something responsible like not increase the debt ceiling and everyone flees to the Yen? The currency of a country with one of the highest debt to GDP ratios in the developed world. Makes perfect sense…
burk85 Wrote: ------------------------------------------------------- > This reveals how dumb the “animal spirits” are. > So the US may do something responsible like not > increase the debt ceiling and everyone flees to > the Yen? The currency of a country with one of > the highest debt to GDP ratios in the developed > world. Makes perfect sense… Again, not looking for a political debate here. Merely an academic discussion of MPT without a risk free asset. Thanks to all who are posting constructive comments. Very much appreciated.
Dat Maz Wrote: ------------------------------------------------------- > burk85 Wrote: > -------------------------------------------------- > ----- > > This reveals how dumb the “animal spirits” are. > > > So the US may do something responsible like not > > increase the debt ceiling and everyone flees to > > the Yen? The currency of a country with one of > > the highest debt to GDP ratios in the developed > > world. Makes perfect sense… > > > Again, not looking for a political debate here. > Merely an academic discussion of MPT without a > risk free asset. Thanks to all who are posting > constructive comments. Very much appreciated. My post was a comment on the reaction of the market to a political decision and had nothing to do with a political debate. Just as your question dealt with the implications to MPT because of a political decision. I suggest if you want to so tightly control to direction of a thread you start your own forum. To you question: It was already answered in the first response. “MPT will still hold because in the absence of risk free asset, then the zero beta portfolio will apply.” The APT model is more robust than the CAPM anyway. In practice, most people do not hold treasuries to maturity. Therefore there is variability in its price and thus risk. In theory, as already stated, the zero beta portfolio would replace the risk free security. While a zero beta portfolio is hard to maintain in practice so is unlimited and cost-less borrowing/lending at the risk free rate. MPT lives on…
Appreciate the feedback.