Risk-Free Rate
IntermediateThe risk-free rate is the theoretical return on an investment with no risk of loss, used as a baseline for measuring the extra return that riskier investments must offer. In practice, it is usually represented by the yield on government bonds of a stable country.
No investment is truly free of all risk, but bonds issued by governments with strong credit, in their own currency, come closest because the chance of default is considered extremely low. Short-term treasury bills are often used for short-term analysis, while longer-term government bond yields, such as ten-year yields, are commonly used in company valuation.
The risk-free rate is a building block in many financial calculations. In the Capital Asset Pricing Model, the cost of equity equals the risk-free rate plus a risk premium. The Sharpe ratio measures returns above the risk-free rate. Option pricing models also use it.
For example, if ten-year government bonds yield 4% and investors require an equity risk premium of 5% for an average share, the expected return on that share would be about 9%.
The risk-free rate changes with interest rates and economic conditions. When it rises, the required returns on all other investments tend to rise too, which lowers the present value of future cash flows and can reduce the value of shares, property and other assets.
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