Risk Free Rate Analysis

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Risk free rate refers to the yield on high quality government bonds. The number of models and theories that are based around the concept conveys its importance in finance. They include risk premium and models such as the capital asset pricing model. Like most models it is held to a set of assumptions. Theoretically there should be zero risk involved to the investor. Below I will discuss risk free rate and its importance on finance (Damodaran, 2010).

The most common risk free interest rate is the short term US Treasury bond and is seen as a proxy. It is therefore valued as the default risk entity. They are seen as the most liquid bonds on the market (Buttonwood, 2014). It is considered easy to obtain and therefore most efforts are focused estimating the risk parameters of individual companies and risk premiums based on it (Damodaran, 2011). Risk free rate of return is critical for measuring present value. It recognizes that cash today is not the same as it is in the future. If invested we should expect that the time value of money will remain the same. These are key elements in the financial world and important indicators for investors.

The measurement of risk is the main reason for the concept of risk free rate and its importance to the theory of finance. All investments are made with the expectation that returns will be made over the life of the asset. Risk free rate comes into effect when the actual and expected rate of return differs. The concept of risk free is that actual returns equal expected returns. An investment is risk free when there is no variance around the return (Damodaran, 2014). This introduces the concept of risk premium. Risk premium is calculated by deducting the riskier return from the risk free rate. T...

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...ar flaw in the financial system.

Many critics have stated that the economic crack in 2008 has exposed the weaknesses in the traditional financial models including risk free rate. As a traditional cost of equity input there has been a significant decline in yields on risk free government securities. At the time many central banks brought up much of the medium and long-term bonds which some say is a cause of the lower yields (Grabowski, 2014).

There is nothing truly risk free. Actions are always risky because the future is unknown and all actions have a measure of risk. But as we can see with the majority of return models risk free rate is extremely important. Can this be solved if risk free rate gets a new definition? Should it be the lowest rate risk with return? Fisher claims that many investors see risk free rate as good enough measurement (Fischer, 2014).

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