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Central Bank Credit Risk and a New Risk-Free Benchmark

NEW YORK ( TheStreet) -- The concept of risk-free rate (meaning that it's free of credit risk) is one of the most fundamental pillars of modern finance theory.

It is used to derive the pricing of all derivatives, even if that's done with shaky, oversimplified assumptions.

The risk-free rate had been assumed to be the relevant sovereign yields, in most cases those of the U.S., before the 2008 financial crisis. But the continuing crises have called into question the notion that major sovereigns are free of credit risk.

Furthermore, the central bank interventions of the past several years have destroyed the pricing framework. Central banks have not only distorted the market by coming in as significant, profit-insensitive players, but also by manipulating outright the shape of the yield curve (e.g., Operation Twist).

As another example, the Federal Reserve's QE3 has pushed 30-year agency bond yields below those of comparable Treasuries, as shown by T. Rowe Price.

Surely this has left derivatives quants, risk managers and traders cringing in pain around the world.

The impact of this central bank distortion is much greater and wider than the average investor realizes. It is on the same scale as the Libor scandal, but I suspect that it is underappreciated outside the financial world.

When the risk-free benchmark is in question, so are all derivatives prices, risk valuation and related hedging. You don't know how to judge prices, you don't know whether an arbitrage opportunity is actually a trap and you don't know how much risk you have taken on. Even if you are confident in your guesstimate, you don't know how to hedge it or whether the hedge will work as expected.

I suspect the "London Whale" episode is related to this risk distortion in many ways. The combination of rising sovereign credit risk and distortion of all principle reference curves has rendered quantitative finance irrelevant; it would not have existed today if not for the sheer lack of motivation to get rid of useless departments at major banks. It is as if we are back to the stock option days before Black-Scholes.

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