I have noticed that under some of the methods used for valuing the liabilities such as the market-based approach and the risk-neutral market-consistent approach, it says that the discount rate we use should be a deduction from the rate we use to allow for default risk (and any other associated risks). So for the market-based approach, it says there would be a deduction from the expected return due to default risk. Similarly, under the risk-neutral armlet consistent approach, it says any risk elements from the risk-free yield should be stripped out. I am just a bit confused as to why we do this. Is it to be more conservative, so by reducing the discount rate we allow for the risks (like default) by having a higher value on our liabilities?
Hi Claudio, The course notes say that for coming up with a risk-free rate, we need to ensure that any 'risk' element in the yields need to be taken out, to make it fully risk free. Likewise with the market-based approach reflecting assets held, we would want the actual return, without considering the 'additional' rate for default. Liabilities won't default, so we'd want to reflect that in valuing the liabilities.
