Economic and Financial Reports Volume 05/2010

Uncovering the common risk free rate in the European Monetary Union

In this paper the Common Risk Free (CRF) rate represents the return on a hypothetical common bond without default and liquidity risk. The CRF rate equals the minimum possible aggregate nominal funding costs of the union’s member states, and reflects the fundamentals of the union’s economy. Since we analyse long-term instruments, the CRF bond is however not free of inflation and market risk (i.e. the variability of short-term interest rates). The CRF rate includes the common part of the inflation risk premium across the members of the monetary union. Adjusting the bond yields for cross country differences in this premium is unnecessary because international investors are not affected by inflation outside their country of residence.