Risk-free rate
The risk-free rate is the theoretical return on an investment with no default risk, typically proxied by a short-term government bond yield. It is the baseline to which risk premiums are added.
FrameworkCAPM
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Required return of 9.5% equals the risk-free rate of 3.5%, proxied by a three-month Treasury bill, plus a risk premium of 6%, found by multiplying a beta of 1.2 by a 5% market risk premium. The risk-free rate is the floor: every risky asset must earn more than the government can pay with no default risk.
Where it fits
TopicRisk, Return & the CAPMCoreSubjectCorporate FinanceCore
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PracticeCORE
In applying the CAPM to estimate a firm's cost of equity, the risk-free rate is most commonly proxied by which of the following?
Select an answer to check your understanding.