Risk-Free Rate

What is Risk-Free Rate?

The risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to equal to the interest paid on a 3-month government Treasury billTreasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument issued by the US Treasury with maturity periods from a few days up to 52 weeks., generally the safest investment an investor can make.

The risk-free rate is a theoretical number since technically all investments carry some form of risk, as explained hereRisk and ReturnIn investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk.. Nonetheless, it is common practice to refer to the T-bill rate as the risk-free rate. While it is possible for the government to default on its securities, the probability of this happening is very low.

The security with the risk-free rate may differ from investor to investor. The general rule of thumb is to consider the most stable government body offering T-bills in a certain currency. For example, an investor investing in securities that trade in USD should use the U.S. T-bill rate, whereas an investor investing in securities traded in Euros or Francs should use a Swiss or German T-bill.

How does the risk-free rate affect the cost of capital?

The risk-free rate is used in the calculation of the cost of equityCost of EquityCost of Equity is the rate of return a shareholder requires for investing in a business. The rate of return required is based on the level of risk associated with the investment (as calculated using the CAPMCapital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security), which influences a business’ weighted average cost of capitalWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.. The graphic below illustrates how changes in the risk-free rate can affect a business’ cost of equity:

Where:

CAPM (Re) – Cost of Equity

Rf – Risk-Free Rate

β – BetaBetaThe beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.

Rm – Market Risk PremiumMarket Risk PremiumThe market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets.

A rise in Rf will pressure the market risk premium to increase. This is because as investors are able to get a higher risk-free return, riskier assets will need to perform better than before in order to meet investors’ new standards for required returns. In other words, investors will perceive other securities as relatively higher risk compared to the risk-free rate. Thus, they will demand a higher rate of returnRisk and ReturnIn investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. to compensate them for the higher risk.

Assuming the market risk premium rises by the same amount as the risk-free rate does, the second term in the CAPM equation will remain the same. However, the first term will increase, thus increasing CAPM. The chain reaction would occur in the opposite direction if risk-free rates were to decrease.

Here’s how the increase in Re would increase WACCWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.:

Holding the business’ cost of debt, capital structure, and tax rate the same, we see that WACC would increase. The opposite is also true (i.e., a decreasing Re would cause WACC to decrease).

Further Considerations

From a business’s perspective, rising risk-free rates can be stressful. The company is under pressure to meet higher required return rates from investors. Thus, driving stock prices up and meeting profitability projections become high priorities.

From an investor’s perspective, rising rates are a good sign since it signals a confident treasury and the ability to demand higher returns.

Historical U.S 3-month T-bill Rates

Below is a chart of historical U.S. 3-month T-bill rates:

T-bills fell as low as 0.01% during the 1940s and 2010s and rose as high as 16% during the 1980s. High T-bill rates usually signal prosperous economic times when private sector companies are performing well, meeting earnings targets, and increasing stock prices over time.

Additional Resources

To learn more about related topics, check out the following CFI resources:

• WACC CalculatorWACC CalculatorThis WACC calculator helps you calculate WACC based on capital structure, cost of equity, cost of debt and tax rate. Weighted Average Cost of Capital (WACC) represents a company's blended cost of capital across all sources, including common shares, preferred shares, and debt.  The cost of each type of capital is weighte
• Cost of DebtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis.
• Capital StructureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure
• Capital Assets Pricing ModelCapital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security