how/where to find risk free rate... a little confused

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Hello everybody

I was looking at the vault guide to finance interview from 2005 and I see that:

rf=risk free rate= long term t bond rate= 10%
(rm-rf)=long term risk premium= 8% (I know some say it should be 7% in US market, but in the example they use 8% for some reason)

However, I found that the 10year/30year from Bloomburg to be 3.5%/ 4.375 which is a big difference.
( http://www.bloomberg.com/markets/rates/ )

I am a little confused as to what rf and (rm-rf) are today and would appreciate some help. Do they change?(I thought they might because of a decrease in interest rates) If so, does anybody know what they are today or how I can find/calculate them? I need them to calculate the discount rate in the following equation:

discount rate= rf+beta(rm-rf)

Thanks

Determining Risk Free Rate

From the Wall Street Oasis Finance Dictionary

The risk free rate is a key concept when valuing potential investments and balancing portfolios. It is simply the current interest rate paid on any investment deemed to be 'risk free' (i.e. US/UK/German government bonds, savings accounts etc.). All other forms of investment should pay a higher interest rate than these, or else it is not worth investing in them for the additional risk taken on.

The risk free rate is used in the Capital Asset Pricing Model to value assets, and all portfolios should contain a certain percentage of money in risk-free assets as a means of diversification

Thoughts from the community on risk free rate.
from certified user @smuguy97

Technically, you should use the 3-month (13 weeks) T-Bill interest rate.

I'm sure Vault is using 10% for simplicity's sake - that would be an insanely high risk-free rate.

1.34% should be fine to use, although for academic purposes I'm sure anything between 1% and 5% is acceptable.

Here's a helpful video from the NYU stern about determining the risk free rate.


Recommended Reading

Comments (36)

Apr 1, 2008

Reason is is low is because of the current interest rates. Use the 10 year T-bill rate and put that in for the risk free rate.

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Apr 1, 2008
KMM:

Reason is is low is because of the current interest rates. Use the 10 year T-bill rate and put that in for the risk free rate.

By using the 10 year rate don't you expose yourself to some maturity risk?
Oh and f... it, I am going into sales why should I care?

Remember, you will always be a salesman, no matter how fancy your title is.
- My ex girlfriend

Apr 1, 2008

Correct me if I am wrong, but in the US rf is the 1 year treasury bill, and you can get the rate here:
http://www.treas.gov/offices/domestic-finance/debt...
Although that is assuming the US does not default, which could happen. But then finance would be of no use since we would get a huge war and everybody will die.

Again, I might be completely wrong.

Remember, you will always be a salesman, no matter how fancy your title is.
- My ex girlfriend

Apr 1, 2008

Technically, you should use the 3-month (13 weeks) T-Bill interest rate.

Apr 1, 2008

They would just print more money. The value of the dollar vs. other currencies could be in question but they own a printing press!

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Apr 1, 2008

The risk free rate is theoretical. Use an on-the-run, short-term T-bill as a proxy.

Same thing with the market risk premium, it is not observable, its an approximation.

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Apr 1, 2008

for (rm-rf), I was planning on using 7%. However, I just wanted to double check with everyone and make sure that I am suppose to use the three month t-bill rate.
The only reason I am a bit confused is becuase from 2005 (when the vault guide to finance interviews was written), the guide uses 10% as the risk free rate and I am going to be using 1.34%instead, which makes me a bit nearvous since it is such a big difference. What do you guys think about that?

Apr 1, 2008

I'm sure Vault is using 10% for simplicity's sake - that would be an insanely high risk-free rate.

1.34% should be fine to use, although for academic purposes I'm sure anything between 1% and 5% is acceptable.

Apr 1, 2008

"technically" there's no right answer but most academics rely on the 3-month T-bill for mean-variance/CAPM analysis.

Apr 1, 2008
Jack Bauer:

"technically" there's no right answer but most academics rely on the 3-month T-bill for mean-variance/CAPM analysis.

Same goes for APV --unleveraged--right (since that is what I am using)?

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Apr 1, 2008

I don't think anyone actually uses APV...

Apr 1, 2008

has no debt

Apr 1, 2008

Use rf = 5% and rm = 10%; that's what my finance professors used in my undergrad. Plus those were the rates back when most text book cases were wrote...
You can just tell them "assuming an rf of and a rm of". And of course tell them what the rf technically should be etc....

Remember, you will always be a salesman, no matter how fancy your title is.
- My ex girlfriend

Apr 1, 2008

there is no correct answer regarding rf but most academics and most practitioners use the 10yr treasury, contrary to what a couple of people above have said. the three valuation books on my bookshelf (Damodaran, Arzac and McKinsey) all recommend a 10yr treasury. with regards to rm-rf (or the equity risk premium), banks use to use around 7% but most lowered to between 3-5% over recent years. i don't think anyone has a clue right now what the appropriate premium should be today given how low treasury yields are (due to the credit issues). its fair to say that today's 10 yr rate (3.5%) plus 5% ERP is probably too low a cost of equity for the market but that's what i would use.

Apr 1, 2008

Not trying to get into a technical argument here, but it seems to me that any t-note with a duration of more than two years carries a relatively larger reinvestment risk premium / discount than would zero coupon t-bills with durations of 91 or 182 days that aren't distributing coupon payments every six months.

Either way, ex-banker is correct that there is no one "right" answer. As a side note, one decent rule of thumb I've also heard is to use the yield on treasuries with similar investment horizons.

Apr 1, 2008

smuguy, it's late and i'm tired so sorry if i am misunderstanding what you wrote, but i think your first paragraph is not right. a zero coupon 3-month t-bill matures in 3 months so i have reinvestment risk on my full principal in 3 months. in a 2-yr note, i do have a reinvestment risk on the coupon every 6 months ( still less risk than if it were every 3 months) but i don't have reinvestment risk on the principal for 2 years. in other words, the longer term security has less reinvestment risk, though a zero coupon long-term note/bond is even better.

in the context of WACC and DCF, you do indeed want to try to match the duration of the risk free security with the approximate duration of your cashflows (i think this is what you are stating in your second paragraph).

Apr 1, 2008

ex-banker, I'm pretty exhausted as well so we may be simply talking past one another, but the reinvestment risk I was referring to comes from the fact that the yield on 10 year treasuries is almost entirely driven by assumptions around coupon reinvestment. Because zero coupon t-bills pay out an explicit yield based on their upfront price and principal payout at maturity, you know exactly what kind of return you will receive upon maturity(assuming no default risk, of course).

Reinvestment of the principal amount is a separate issue, since you're only looking at a risk free return for a given investment horizon (albeit a shorter one). If interest rates move around when a t-bill expires, your new risk free rate should adjust accordingly, but this isn't an explicit "risk" since you'll once again know what kind of yield to maturity to expect (i.e., it's not a matter of trying to maximize your risk free return, but rather trying to best approximate the risk free rate of return).

It's been a long day and my I'm finally heading out of the office, but hopefully that provides at least some clarity.

Apr 2, 2008

I was always under the impression that the investment horizon serves drives the risk free rate. For short term holding the three month treasury would be best, and for long term the 10 year treasury would be better.

Apr 1, 2008

all i know is that if i keep getting into dicussions about WACC at 2:00am, I'm going to have to remove the "ex" from ex-banker

Apr 2, 2008

My view (and the general academic consensus) is that the 20-year treasury yield is the most correct RFR if you are using Ibbotsen equity risk premia, since their data is also 20-year averaged over the term since inception of their data tracking.

Apr 2, 2008

We're trying to price some debt right now and it's actually starting to become an issue. Last week we spoke with our lenders and the general sentiment was "they'll figure it out". Speaking with them again today, they're still confident, but I get the sense it's one of those "we can't even fathom what happens without a risk free rate, so we're just going to ignore it".

Not to mention most debt is priced in terms of LIBOR, which I assume they'll figure out in event of default.

Apr 2, 2008
CaptK:

We're trying to price some debt right now and it's actually starting to become an issue. Last week we spoke with our lenders and the general sentiment was "they'll figure it out". Speaking with them again today, they're still confident, but I get the sense it's one of those "we can't even fathom what happens without a risk free rate, so we're just going to ignore it".

Not to mention most debt is priced in terms of LIBOR, which I assume they'll figure out in event of default.

haha nice

Apr 2, 2008

lol

Apr 2, 2008

I have long argued that the proper risk-free rate is zero percent.

Apr 2, 2008
alexpasch:

I have long argued that the proper risk-free rate is zero percent.

id say negative inflation rate

Apr 2, 2008

Make no mistake -- Treasuries will continue to be the risk-free asset.

Apr 2, 2008

I'd probably say: "Use US/other developed country sovereign bond YTM and add country risk premium later on".

Apr 2, 2008

...

Apr 2, 2008

it depends IMO. if a afghan company is trying to list on NYSE, then the Rf should be the expected return of bond issued by afghan government in dollar (which is undoubtedly much higher). while if only in Afghanistan, the expected return of bond issued by afghan government in local currency.

Apr 2, 2008

You could probably back into it based on the US risk free rate and the FX forward rate which would give you a market price for the Afghan analogue to the risk-free rate. I would mention also that the term "risk-free" in the context of Afghanistan is just the baseline for riskiness conditioned on having already chosen to invest in that country, rather than a statement of a zero-risk environment - clearly there is a lot of risk in the Afghan political situation. One could also make the argument that since the US is so intertwined with the fate of Afghanistan, that we would not allow a default event in Afghanistan in the near future so over the immediate horizon the risk free rate in Afgh. is equal to the US risk free rate.

Apr 2, 2008

U sure it wasn't market risk premium they were using?

Apr 2, 2008
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Apr 2, 2008
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