What is the risk-free rate?
In short:
A risk-free rate (RFR) is the rate of return on an investment with zero risk over a period of time.
More specifically, the risk-free rate represents no default risk or reinvestment risk for the investor. As you can expect, this is a theoretical value as every investment, in reality, carries risk. That said, in practice, an investor can use government bonds or bills as the risk-free rate since a government can print money to cover its obligations and thus eliminate default risk.
Knowing the RFR is crucial as more risky assets are priced relative to this zero-risk investment.
In-depth:
Intuitive example
The importance and use of a risk-free rate is actually very intuitive. For example, if you were an investor needing to decide between investment A and investment B. Now investment A has a guaranteed return of 6% and investment B has a 90% chance of a 6% return which would you choose? The logical answer is investment A since you are guaranteed a 6% return.
The example above leads to the question “what would investment B need to be expected to return for someone to choose B over A?”. This should highlight the importance of the RFR, it is the relative point that riskier assets are measured against. From this point expected returns for other assets can be calculated as well as costs of capital.
Risk-free rate In Practice
Bringing the theoretical idea of a risk-free rate into practice is done by using government securities such as government bonds or bills. The reason government bonds or bills are used is because the government has the ability to print money, thereby ensuring that an investor gets the nominal value they were promised. The big problem with this is that a government printing money devalues the money. So, you may get the money you were promised it just might not be worth what it would have been, ie the difference between real and nominal.
Governments often issue debt of varying maturities which then have different yields. Choosing the correct maturity length for a RFR then depends on the length of the alternative investment. Using a U.S. 3-month T-bill against an alternative 10-year investment would not be the best choice. Instead, a U.S. 10 Year Treasury Note may be a better selection.
It is very important to use the correct currency when using government securities for a RFR in valuation. If the company for which an expected return is being calculated does its business in British pounds, then the RFR should be that reflecting British pounds.
Using the risk-free rate
Calculating the alternative return often called the expected return or discount rate for an investment which is not a risk-free investment, is of great debate. Assuming the alternative investment is a publicly traded company the most common approach is to use the Capital Asset Pricing Model. This calculation factors in the systematic risk a company brings to a portfolio where the RFR is a key factor. The formula below can be better explained with our documentation on CAPM.
Where to find risk-free rates
US government bond and bill rates are widely available on many stock data websites. They can also be found by visiting the US Treasury Website.