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 bill, 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 here. 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 equity (as calculated using the CAPM), which influences a business’ weighted average cost of capital. The graphic below illustrates how changes in the risk-free rate can affect a business’ cost of equity:
CAPM (Re) – Cost of Equity
Rf – Risk-Free Rate
β – Beta
Rm – Market Risk Premium
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 return 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 WACC:
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).
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.
To learn more about related topics, check out the following CFI resources: