Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
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 be equal to the interest paid on a 10-year highly rated government Treasury note, 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-note rate as the risk-free rate. While it is possible for a highly rated government to default on its securities, the probability of this happening is considered 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-notes in a certain currency. For example, an investor investing in securities that trade in USD should use the U.S. T-note rate, whereas an investor investing in securities traded in Euros or Francs should use the equivalent Swiss or German note.
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’s weighted average cost of capital. The graphic below illustrates how changes in the risk-free rate can affect a business’ cost of equity:
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 problematic. The company might have to adjust its internal investment policies to meet higher required rates of return demanded by investors.
Historical U.S 10-year T-note Rates
Below is a chart of historical U.S. 10-year T-note rates:
Source: St. Louis Fed
T-notes fell as low as 0.52% during the Covid pandemic and rose as high as 15.84% during the early 1980s. High T-notes rates usually signal prosperous economic times when private sector companies are performing well, meeting earnings targets, and increasing stock prices over time.
Thank you for reading CFI’s guide on Risk-Free Rate. To learn more about related topics, check out the following CFI resources:
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.