Risk-Free Rate
The theoretical return on an investment with zero risk, typically approximated by short-term government bond yields.
What is Risk-Free Rate?
The risk-free rate is the return an investor expects from an absolutely risk-free investment over a specific time period. In practice, it is approximated by the yield on short-term government securities in a country with a stable currency — most commonly the US Treasury bill rate or, for longer durations, the 10-year Treasury yield. The risk-free rate is a critical input in asset pricing models: CAPM uses it as the baseline return, WACC incorporates it through the cost of equity formula, and options pricing models such as Black-Scholes include it directly. When the risk-free rate rises, it increases the discount rate applied to future cash flows, reducing the present value of all risk assets. Low risk-free rates in the 2010s inflated asset valuations; rising rates in 2022–2023 reversed much of that expansion.
Example
In early 2022, the 10-year Treasury yield was approximately 1.7%, resulting in low discount rates and high equity valuations — the S&P 500 traded at a forward P/E of about 22x. By late 2022, the Fed had raised short-term rates to over 4%, and 10-year yields climbed above 4.2%. Using a higher risk-free rate in CAPM raised required returns and WACC, justifying lower valuations. The S&P 500's forward P/E compressed to about 15x — illustrating how directly the risk-free rate affects all asset prices.
Source: Federal Reserve Bank of St. Louis — 10-Year Treasury Rate