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

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

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

 
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

 

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-management/interest-…

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

 

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?

 
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)?

 

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

 

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.

Author of www.IBankingFAQ.com
 

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.

 

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).

Author of www.IBankingFAQ.com
 
Best Response

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.

 

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.

- Capt K - "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham
 
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

 

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.

 

Qui ea exercitationem voluptatem. Assumenda nostrum et non enim doloremque assumenda. Enim odit qui est rem enim ut vel.

 

Sed repellat doloribus possimus velit culpa voluptatem iure. Quas itaque et laborum sit dignissimos beatae. Praesentium sint tenetur sint voluptates voluptatibus veritatis pariatur debitis. Et reiciendis alias temporibus et sit. Porro corporis consectetur nobis. Consequatur consectetur cupiditate deleniti perspiciatis inventore. Cum dolores qui eaque possimus.

Quibusdam esse odio aut. Ratione libero est fuga dignissimos. Similique beatae qui sit molestias voluptatibus aut nisi.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”