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 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:

Where:

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).

Further Considerations

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.

Additional Resources

Thank you for reading CFI’s guide on Risk-Free Rate. To learn more about related topics, check out the following CFI resources:

• WACC Calculator
• Cost of Debt
• Capital Structure
• Capital Assets Pricing Model
• See all valuation resources
• See all risk management resources