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Why a Broad Bond Index Is Not a Risk-Free CAPM Proxy

Article Quant Q&A · Author: sotnik
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Summary

The document considers whether a bond index can stand in for the risk-free rate in the Capital Asset Pricing Model. One response argues that broad bond indexes can contain government, municipal, corporate, high-yield, mortgage-backed, and loan exposures, so their returns and yields include credit and other risks absent from a risk-free benchmark.

A second response emphasizes that the choice depends on the analyst's definition of a risk-free rate. In the CAPM framework, this rate represents an assumed borrowing or lending return without risk; a volatile bond index may not meet that role. The discussion mentions Treasury and interbank reference rates as possible conventions, but provides no empirical test or universal selection rule. The appropriate proxy therefore depends on the model's assumptions, market, and investment horizon.

Key ideas

  • A broad bond index can include credit and other non-risk-free exposures.
  • CAPM's risk-free rate represents a borrowing or lending benchmark assumed to carry no risk.
  • The choice of proxy depends partly on how the analyst defines the risk-free rate.
  • The discussion gives conceptual arguments but no empirical comparison or universal rule.

Tags

Fixed incomePortfolio constructionStatisticsUS markets
Full text
# CAPM: Bond index as proxy for Rf


# CAPM: Bond index as proxy for Rf












Is it possible to use a bond index as a proxy for Rf in CAPM? Please let me know what is the issue here.

## Answer by Vansh Berry (score 1)

https://quant.stackexchange.com/a/41943

Bond index is a composition of government bonds, municipal bonds, corporate bonds, high-yield bonds, mortgage-backed securities, syndicated or leveraged loans, etc. Whereas Rf is risk free rate is typically equal to the yield on a 10-year US government bond,which is essentially risk free unlike bond index. Using bond index would not lead to an accurate CAPM.

## Answer by DeltaZen (score 1)

https://quant.stackexchange.com/a/41957

It depends on how you define the risk-free rate and you should be able to show persuading reasons once you choose a rate to be risk-free , whatever Libor rate or Treasury rate or others. I remember in CAPM, the risk-free rate also represents the rate at which an investor can lend or borrow money without committing losses to build an efficient portfolio, so this rate should in theory be not volatile, a bond index would not fit this requirement I think.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.