Risk‐free Rate

This chapter examines the risk‐free rate that serves as a building block for many of the cost‐of‐equity capital models. A risk‐free rate is the return available, as of the valuation date, on a security that the market generally regards as free of the risk of default. The choice of which risk‐free rate to use is based on, first, matching the expected duration of the net cash flows of the investment and, second, matching the duration of data used to develop an estimate of the equity risk premium (ERP). Beginning with the global financial crisis of 2008 analysts have had to reexamine whether the “spot” rate continued to be a reliable building block upon which one should base his/her cost of equity capital estimates. The chapter discusses these issues by first examining the underlying components of risk‐free rates.