Performance Perspectives Blog

Which risk-free rate to use when investing in other countries?

by | Mar 26, 2014

A client sent us a question that I am a bit surprised hasn’t been asked before: which country’s risk-free rate should be used when investing across countries?

For example, if a US domiciled investor has a Japan-based asset, when we calculate the Sharpe ratio, should we use a US risk-free rate or one from Japan? Likewise, if we have a client in Japan for whom we’ve purchased assets in the UK, which country’s risk-free rate should we employ?

In risk-adjusted return measures such as the Sharpe ratio, we use the risk-free return to derive the risk premium (portfolio return minus risk-free return). It’s the premium the investor is entitled to, for taking on more risk.

If the portfolio manager picks a Japanese asset, presumably it’s because they want to gain exposure to that market. And so, to me, the alternative risk-free asset would be one from Japan.

A challenge arises when we invest in a country (e.g., emerging market) where there is no risk-free asset. In these cases, I would think it reasonable to default to the risk-free asset of the investor’s home country. These are views that I’ve come up with without the benefit of discussion with others, and so I am open to being corrected, enlightened, persuaded to adopt alternative ones.

This is an interesting topic, I believe, that is worthy of much discussion. This is the first time I’ve opined on it, and am curious what you think, so please offer your comments!

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