Risk-Free Rate

What is a Risk-Free Rate?

A 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 considered to equal a 3-month government Treasury billTreasury Bills (T-Bills)Treasury Bills (T-Bills) are a short-term financial instrument that is issued by the U.S. Treasury with maturity periods ranging from a few days to 52 weeks. They are considered the safest debts since they are backed up by the full faith of the Treasury Department of the United States Government. When an investor buys, since this is generally the safest investment an investor can make. A 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 as the risk-free rate. While it is possible for the governments to default on their securities, the probability of this happening is very low; hence the investment is considered “Risk-Free.”

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 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, which is measured as the historical volatility of returns. Learn the cost of equity formula with examples and download the Excel calculator (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 WACC formula  is = (E/V x Re) + ((D/V x Rd)  x  (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator. The graphic below illustrates how changes in the Risk-Free rate would 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 will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets. The market risk premium is part of the Capital Asset Pricing Model (CAPM) which analysts and investors use to calculate the acceptable rate

In our example, a rise in Rf will pressure the market risk premium to increase. It is because as investors are able to get a higher risk-free return, risky assets will need to perform better than before in order to meet the investors’ new standard for required returns. In other terms, investors will perceive other securities as riskier than before and thus 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 increased 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 also occur in the opposite direction if risk-free rates were to decrease (i.e., a lower risk-free rate would result in lower cost of equity).

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. The WACC formula  is = (E/V x Re) + ((D/V x Rd)  x  (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator:

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

From an investor’s perspective, rising risk-free 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 where 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 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. Learn the formula and methods to calculate cost of debt for a company based on yield to maturity, tax rates, credit ratings, interest rates, coupons, and
• 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.  The structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions,
• 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