The Risk-Free Asset Implied by the Market: Medium-Term Bonds instead of Short-Term Bills

Abstract

In empirical tests of the CAPM, the theoretical risk-free asset is typically assumed to be 1-month Treasury bills. This paper examines the implications of a mis-specified risk-free asset, i.e. the possibility that the ‘true’ risk-free asset is a longer-maturity Treasury bond. A simple theoretical derivation leads to the testable prediction that low-beta (high-beta) stocks should then exhibit positive (negative) bond betas. We find strong empirical confirmation for these predictions. The market-implied risk-free asset can be pinpointed at medium-term (5-year) bonds. Concrete implications of this finding are a lower equity risk premium and a less steep security market line.