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I was reading Options,Futures and Other Derivatives by John Hull and I came across the question:

Why are US Treasury rates significantly lower than other rates that are close to risk-free?

I cannot think of an answer why this is true?

  • What specific other "close to risk-free" rates do you have in mind? – Mike Scott Jan 28 '15 at 21:09
  • You mean, like put options on the Swiss Franc? Or like Class A mortgage-backed securities? Or ... – Joe Jan 28 '15 at 21:12
  • I dont know, I guess John Hull meant AA rated govt and corporate bonds? – Victor123 Jan 28 '15 at 21:16
  • Like AIG or Lehman Brothers? – Joe Jan 28 '15 at 22:30
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As I'm sure you are reading in Hull's classic, the basic valuation of bonds depends on the chance of entity defaulting on those bonds. Let's start with just looking at the US. The United States has a big advantage over corporations in issuing debt as it also prints the same currency that the debt is denominated in. This makes it much easier not to default on your debt as you can always print more money to pay it. Printing too much currency would cause inflation lowering the value of debt, but this would also lower the value of US corporate debt as well. So you can think of even the highest rated corporate bonds as having the same rate as government debt plus a little extra due to the additional default risk of the corporation.

The situation with other AA rated governments is more complicated. Most of those governments have debt denominated in their local currency as well so it may seem like they should all have similar rates. However, some governments have higher and some actually have lower rates than the United States. Now, as above, some of the difference is due to the possible need of printing too much currency to cover the debt in crisis and now that we have more than one country to invest in the extra risk of international money flowing out of the country's bonds.

However, the bigger difference between AA governments rates depends more on money flow, central banks and regulation. Bonds are still mostly freely traded instruments that respond to supply and demand, but this supply and demand is heavily influenced by governments. Central banks buy up large portions of the debt raising demand and lowering rates. Regulators force banks to hold a certain amount of treasuries perhaps inflating demand.

Finally, to answer your question the United States has some interesting advantages partially just due to its long history of stability, controlled inflation and large economy making treasuries valuable as one of the lowest risk investments. So its rates are generally on the low end, but government manipulation can still mean that it is not necessarily the lowest.

  • Thank you for the beautiful answer. Better than a textbook. – Victor123 Jan 29 '15 at 15:22

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