“VMC: What Is Risk-Free Rate?” was originally published here.

**Q3 2020 hedge fund letters, conferences and more**

**Table of Contents**Show

## Definition of Risk-Free Rate

- The risk-free rate is the minimum rate of return on an investment with theoretically no risk.
- Government bonds are considered risk-free because technically, a government can always print money to pay its bondholders.
- It is also the rate that provides an investor with some return and some compensation for future
__inflation.__ - These two components are referred to as the
__real-risk free rate__and the__inflation premium.__ - For practical purposes, the 10-Year U.S. Government Treasury bond can be considered the (nominal) risk-free rate.
- There is still a risk that the coupons payments a Treasury bondholder earns are reinvested at different, prevailing interest rates.
- Therefore, some people consider a more accurate risk-free rate to be a short-term U.S. Treasury Bill.
- But remember that when a short-term bond expires, the proceeds must be reinvested at the prevailing rate, so there is still
__reinvestment risk__for a long-term investor.

## What Factors Influence the Risk-Free Rate?

- The general flexibility of the capital market due to supply and demand.
- Anticipated rate of inflation.

## How To Calculate the Risk-Free Rate?

- Subtract the inflation rate from the yield of the Treasury Bond matching the investment maturity.

**((1 + Government Bond Rate)/(1 + Inflation Rate)) – 1**

## Why is the Risk-Free Rate Important?

- It is the base rate for almost all interest rates and rates of return in a country.
- Used to calculate the cost of capital in the
__Capital Asset Pricing Model (CAPM).__ - CAPM estimates the required rate of return on an investment.

**E(r) = Rf + ****?(Rm – Rf)**

- Used in
__Modern Portfolio Theory,__where investors are expected to maximize the risk-return trade-off.

## Digging Deeper

- Long-term investors in government bonds face two risks: Interest rate risk and reinvestment risk.
- Zero-coupon bonds can solve the problem of reinvestment risk because there is nothing to re-invest since there are no coupons paid.
- U.S. Government TIPS bonds were designed to compensate investors for inflation; hence they provide a real return.
- We can calculate the expected inflation rate as the difference between U.S. 10-Year U.S. Govt bonds and TIPS bonds.
- In global equity valuation, we often use the 10-Year Govt. bond of the country the stock is operating in.
- This is because these bonds tend to be most commonly available; hence, liquid and that makes the interest rate more realistic.
- When a government prints money, it could cause the value of its currency to fall, so investors in another country’s government bonds are also taking on the currency risk.

### Join the Bootcamp for Valuation!

The Valuation Master Class is the complete, proven, step-by-step course to guide you from novice to valuation expert.

**Save with coupon code:** get-smarter

**Click here to learn more and register.**

**Article by Become A Better Investor**