Glossary
Risk-free rate
The return on an investment with essentially no default risk, usually proxied by short-term US Treasury yields, used as a baseline.
On this page
The risk-free rate is the return an investor can earn without taking on credit risk, meaning the chance that the borrower fails to pay. No investment is entirely free of risk, so in practice analysts use the yield on US Treasury securities, which are backed by the federal government's ability to tax and borrow in its own currency. It is the baseline that every other investment is measured against: a risky asset has to offer more than this rate to be worth holding.
How it works
Which Treasury to use depends on the job:
- Short-term work such as option pricing, cash returns and the Sharpe ratio usually uses the 3-month Treasury bill yield.
- Long-term valuation of stocks and projects often uses the 10-year Treasury yield, because the cash flows being valued stretch over many years.
The rate is not fixed. It moves with Federal Reserve policy and with inflation expectations, which is why the same company can be worth noticeably more or less as Treasury yields change.
Nuances
- Real versus nominal. Treasury yields are nominal. The real risk-free rate subtracts expected inflation; Treasury Inflation-Protected Securities (TIPS) yields are a direct market measure of it.
- Not risk-free in every sense. A Treasury held to maturity has no default risk in this framework, but its price can still fall if rates rise, and inflation can erode its purchasing power.
- Other currencies. Analysts valuing euro or yen assets use those governments' bond yields, or a swap rate, as the local baseline.