A Shaky Base: A “Risky” Risk-Free Rate
Risk-and-return models in finance start with an asset that is defined as risk-free and use the expected return on that asset as the risk-free rate. The expected returns on risky investments are then measured relative to the risk-free rate, with the risk creating an expected risk premium that is added to the risk-free rate.
But what makes an asset risk-free? And how do we estimate a risk-free rate? We consider these questions in this chapter. In the process, we have to grapple with why risk-free rates might be different in different currencies and how to adapt discounted cash flow valuations to reflect these differences. We also look at cases where estimating a risk-free rate becomes difficult, and mechanisms ...