Risk-Free Rate
In short
The return on a 'risk-free' investment — usually US Treasury bonds
The rate you earn on the safest available investment, typically short- to medium-term government debt. Everything else gets compared against it — if a 10-year government bond pays 4%, why accept only 3% from a riskier stock or corporate bond with no extra compensation?
No asset is entirely free of risk, so the risk-free rate is a theoretical construct approximated by the yield on government debt from a stable, high-credit-quality issuer — commonly the 10-year yield for long-horizon equity valuation, or a shorter maturity for short-horizon calculations. It's the anchor input for CAPM (cost of equity = risk-free rate + beta × equity risk premium), for WACC, and for options-pricing models. Because it's an observed market rate rather than a ratio with a 'good' or 'bad' level, it moves with monetary policy and macro conditions — it rose sharply during the 2022–2023 rate-hiking cycle, for example. A rising risk-free rate mechanically raises the discount rate used in valuation models, which pushes the present value of future cash flows down, all else equal.
Formula
Typically = 10-Year US Treasury YieldRelated concepts
- WACC — WACC is the average rate a company pays for all its funding — both equity (shareholders expect returns) and debt (banks charge interest). It's the minimum return a company must earn to create value.
- Equity Risk Premium — If government bonds pay 4% and investors demand 10% from stocks to compensate for the extra risk, the difference — 6 percentage points — is the equity risk premium. It's the extra return investors require, on average, for accepting stock market risk instead of a safer bond.
- Fed Funds Rate — The Fed funds rate is the interest rate banks charge each other overnight. When the Fed raises it, borrowing becomes more expensive everywhere — mortgages, car loans, business loans. Higher rates usually hurt stocks, especially growth stocks.