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Risk-free bonds, safe assets and convenience yields
The key difference between convenience yield and the risk-free rate is that convenience yield is related to the non-monetary advantages of holding a specific asset, emphasising its role as a store of value or its usefulness in financial activities. In contrast, the risk-free rate is a fundamental interest rate that represents a baseline return with no risk of loss, often used as a reference point for evaluating investment opportunities and making financial decisions. While both concepts are relevant in finance, they address different aspects of asset valuation and investment analysis.
Recent studies have indicated that investors in developed countries are willing to accept lower returns, referred to as the “convenience yield,” by forgoing potentially higher returns, even when those higher returns come with lower risks. Convenience yields come from factors like an asset’s ease of buying and its safety, how it can be used as a store of value, or as collateral in financial deals. The report indicates that investors are okay with getting a bit less profit in exchange for holding US dollar-based safe assets like US government debt. These assets are trusted, easy to convert into cash, and play a big role in the world’s financial system.
This preference for US safe assets, despite the lower returns they offer, remains even when investors combine foreign safe assets with currency swaps, a practice that contradicts the covered interest parity (CIP) relationship. It’s important to note that, in a currency swap, there is no initial exchange of the principal amounts of the two currencies. Instead, the exchange involves only the interest payments on those principal amounts.
Covered Interest Parity (CIP) is a finance concept that says if you invest in different currencies, after adjusting for expected exchange rate changes, you should make the same profit. In simple terms, if you invest money in one currency or another with the goal of making a return, the difference in interest rates between the two currencies should account for any exchange rate changes. This principle ensures there are no guaranteed profits from exploiting currency market differences when forward contracts (used to hedge against exchange rate changes) are available. However, in the real world, various factors can lead to deviations from CIP, creating opportunities for traders to make money (arbitrage opportunities) until the differences are corrected.
CIP Equation:
The CIP relationship is often expressed as an equation, where:
CIP = (1 + i) / (1 + i*) * F/S
= CIP represents the covered interest parity condition.
= i is the domestic (base) interest rate.
= i* is the foreign interest rate.
= F is the forward exchange rate.
= S is the spot exchange rate.
The equation states that under CIP, the return from investing in the domestic currency (i) is equivalent to the return from investing in the foreign currency (i*) after adjusting for the forward exchange rate (F) and the spot exchange rate (S).
If the CIP condition is met, there should be no riskless arbitrage opportunities available, as investors should not be able to earn a risk-free profit by borrowing in one currency, investing in another, and then using a forward contract to hedge against exchange rate fluctuations.
During financial crises, both dollar convenience yields and CIP deviations increase significantly. This is often attributed to the fact that US safe assets, being denominated in the global reserve currency, offer a larger convenience yield compared to foreign safe assets.
Diamond and Van Tassel directly measure convenience yields in 10 major currencies and find that the dollar’s behaviour can be explained by international arbitrage frictions, rather than a disproportionately large US convenience yield. They revealed that a country’s average convenience yield for government debt is closely related to the level of its interest rates, with a one-percentage-point increase in rates associated with a 15-basis-point higher convenience yield. In comparison to other countries, US convenience yields are moderate, averaging 35 basis points. A basis point is 1/10,000 (1% of 1%).
Convenience yield and the risk-free rate are distinct concepts in finance, each with its unique characteristics and implications:
The key difference between convenience yield and the risk-free rate is that convenience yield is related to the non-monetary advantages of holding a specific asset, emphasizing its role as a store of value or its usefulness in financial activities. In contrast, the risk-free rate is a fundamental interest rate that represents a baseline return with no risk of loss, often used as a reference point for evaluating investment opportunities and making financial decisions. While both concepts are relevant in finance, they address different aspects of asset valuation and investment analysis.
It is essential to note that trends in the demand for safe assets with convenience yield can fluctuate based on the specific circumstances and economic conditions prevailing at any given time. These assets often serve as a means of managing risk within investment portfolios and may see increased demand during times of market volatility and uncertainty. However, the specific trends can vary from one economic period to another. Therefore, it’s important to analyze current economic conditions and investor sentiment to assess the prevailing trend in a particular period.
(The writer, a senior Chartered Accountant and professional banker, is Professor at SLIIT University, Malabe. He is also the author of the “Doing Social Research and Publishing Results”, a Springer publication (Singapore), and “Samaja Gaveshakaya (in Sinhala). The views expressed in this article are solely those of the author and do not necessarily reflect the official policy or position of the institution he works for.)