Topic 24
Risk-Free Rates
This topic explores the notion of risk-free rates as a component of the capital asset pricing model (CAPM) as introduced in Topic 23.
RISK-FREE RATE DEFINED
- The risk-free rate is what an investor would expect to earn on investments in long-term government-issued securities held to maturity.1
- The “risk-free” part is the notion that the central government will not default on the interest or repayment obligation of the security.2
- Risk is what separates equity investments from investments in risk-free government securities.
- With equity investments, you might get back less, get it later, or get nothing.
- Expect more return if you buy a business! Welcome to equity risk!
- The term of the quoted underlying risk-free rate used in a discounted cash flow valuation generally should reflect the expected life of the investment asset, not the expected life of the investor's holding.2
- Usually the longest-term government Treasury rate is utilized.
- Ibbotson utilizes the 20-year U.S. Treasury Bond Yield as the risk-free rate. At year end 2009, this rate was 4.6%.3
- A frequently used source for risk-free data is from Ibbotson Associates, Chicago, Illinois, a subsidiary of Morningstar, Inc., which provides and updates this data annually, provides exceptionally well-documented literature, and has a Web site source (www.ibbotson.com).
1. Ibbotson Associates, 2010 Valuation Yearbook, Market Results for Stocks, Bonds, Bills and Inflation 1926–2009 (222 W. Washington, Chicago, ...
