The risk-free rate of return is a term used in modern financial models to describe a benchmark rate of return with no default risk. This rate is often assumed to be the interest rate on U.S. Treasury debt. The problem with the assumption of a no default interest rate is that it has no grounding in empirical reality. The fact is, governments throughout history, from the Confederacy to the German Reichs have defaulted on their loan obligations. A recent major example is the Russian default on its government debt, which ultimately sent Long Term Capital Management into a financial death spiral. Going back through the ages, governments filled with unscrupulous and amoral men, have ran their institutions into the fate of financial implosion. It is quite silly to think that the U.S. government is somehow an exception and incapable of default. Adherents of the assumption might retort saying that while it may not be realistic, it is still a useful one to make since it is highly unlikely the U.S. will default on its obligations.

Well now, Mr. Market begs to differ. Credit default swaps, instruments designed to mitigate the risk of default, have jumped 4 basis points for U.S. Treasury protection since the AIG bailout, indicating a greater probability of U.S. government default. For those dependent on the risk-free rate for their financial models, say goodbye to it, Secretary Paulson just chucked in the trash. Governments have a way of doing that, you know making willful yet arbitrary decisions that fall 6 or 7 standard deviations from the mean.