Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 7

Riskless Rates and Risk Premiums

All models of risk and return in finance are built around a rate that investors can make on riskless investments and the risk premium or premiums that investors should charge for investing in the average-risk investment. In the capital asset pricing model (CAPM), where there is only one source of market risk captured in the market portfolio, this risk premium becomes the premium that investors would demand when investing in that portfolio. In multifactor models, there are multiple risk premiums, each one measuring the premium demanded by investors for exposure to a specific market risk factor. This chapter examines how best to measure a riskless rate and to estimate a risk premium or premiums for use in these models.

As noted in Chapter 4, risk is measured in terms of default risk for bonds, and this default risk is captured in a default spread that firms have to pay over and above the riskless rate. This chapter closes by considering how best to estimate these default spreads and the factors that may cause these spreads to change over time.

THE RISK-FREE RATE

Most risk and return models in finance start off 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 what do ...