Risk-free rate

Before you rely on it

What to check

Match its maturity to the horizon being analysed, and use the same rate consistently.

The common error

Where people go wrong with risk-free rate

Mixing a short-term rate into one calculation and a long-term one into the next. The comparison between them is then meaningless, and nothing in the output says so.

Worked through

Risk-free rate in plain numbers

A 3-month Treasury bill yields 4% a year; it is treated as the risk-free rate in a model because default risk is considered negligible. In the capital asset pricing model, the expected return on a stock equals the risk-free rate plus beta times the equity risk premium. With a 4% risk-free rate, a beta of 1.2 and a premium of 5%, the expected return is 4% + 1.2 × 5%, or 10%. In a Sharpe ratio, the same rate is subtracted from the portfolio's return, so a 9% return with a 4% risk-free rate has an excess return of 5%; it is the baseline against which risk is measured.

Easily confused

Risk-free rate and its neighbours

The risk-free rate is not the same as a savings account rate or the prime rate; it is the return on an asset assumed to have no default risk, usually short-term government securities of a stable issuer. It is also not zero risk in a real sense: inflation risk and reinvestment risk remain, and longer government bonds carry interest-rate risk; analysts choose a maturity to match the horizon of the cash flows. The rate differs by currency, and there is no single global risk-free rate.

In real decisions

Where risk-free rate turns up

It is an input in valuation, portfolio theory and performance measurement; analysts use it in the cost of equity, in discounting and in the Sharpe and Treynor ratios; investors compare the yield on a risky asset with it to judge the premium they receive. Individuals can think of it as the safe alternative to which every other choice must compare. A higher rate raises the bar for all other investments.

Know the edges

Where risk-free rate stops being reliable

The chosen rate depends on the maturity and the government, and the assumption of no default is a simplification. Rates change, and models are sensitive to the input. During crises, even government securities can trade unusually. Document the choice and test the results at nearby values.

Quick answers

What people ask about risk-free rate

Which rate should I use? Choose a government security whose maturity matches your horizon. Short-term bills for short horizons, ten-year notes for long ones in valuation.

Is the risk-free rate really risk free? It is free of default risk by assumption. Inflation, reinvestment and interest-rate risk remain, and no asset is free of all risk.

Why does it matter to stock valuation? It sets the baseline return investors could earn safely. Higher rates raise the required return on all riskier assets, which lowers values.

Does the risk-free rate change? Yes, daily, with central bank policy and market expectations. Use the value on the date of your analysis.

What is the equity risk premium? The extra return investors expect from stocks over the risk-free rate. Estimates vary with method and period, so treat any figure as a range.