Risk Free Rate Analysis

2293 Words5 Pages
bulb-icon

Recommended: Risk management abstract essay

Risk free rate refers to the yield on high quality government bonds. The number of models and theories that are based around the concept conveys its importance in finance. They include risk premium and models such as the capital asset pricing model. Like most models it is held to a set of assumptions. Theoretically there should be zero risk involved to the investor. Below I will discuss risk free rate and its importance on finance (Damodaran, 2010).

The most common risk free interest rate is the short term US Treasury bond and is seen as a proxy. It is therefore valued as the default risk entity. They are seen as the most liquid bonds on the market (Buttonwood, 2014). It is considered easy to obtain and therefore most efforts are focused estimating the risk parameters of individual companies and risk premiums based on it (Damodaran, 2011). Risk free rate of return is critical for measuring present value. It recognizes that cash today is not the same as it is in the future. If invested we should expect that the time value of money will remain the same. These are key elements in the financial world and important indicators for investors.

The measurement of risk is the main reason for the concept of risk free rate and its importance to the theory of finance. All investments are made with the expectation that returns will be made over the life of the asset. Risk free rate comes into effect when the actual and expected rate of return differs. The concept of risk free is that actual returns equal expected returns. An investment is risk free when there is no variance around the return (Damodaran, 2014). This introduces the concept of risk premium. Risk premium is calculated by deducting the riskier return from the risk free rate. T...

... middle of paper ...

...ar flaw in the financial system.

Many critics have stated that the economic crack in 2008 has exposed the weaknesses in the traditional financial models including risk free rate. As a traditional cost of equity input there has been a significant decline in yields on risk free government securities. At the time many central banks brought up much of the medium and long-term bonds which some say is a cause of the lower yields (Grabowski, 2014).

There is nothing truly risk free. Actions are always risky because the future is unknown and all actions have a measure of risk. But as we can see with the majority of return models risk free rate is extremely important. Can this be solved if risk free rate gets a new definition? Should it be the lowest rate risk with return? Fisher claims that many investors see risk free rate as good enough measurement (Fischer, 2014).

Show More
Related

  • The Financial Crisis of 2007-2008 and The Federal Reserve

    2612 Words  | 6 Pages

    The financial crisis of 2007–2008 is considered by many economists the worst financial crisis since the Great Depression of the 1930s. This crisis resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis led to a series of events including: the 2008–2012 global recessions and the European sovereign-debt crisis. The reasons of this financial crisis are argued by economists. The performance of the Federal Reserve becomes a focal point in this argument.

    Read More

  • The Pros And Cons Of The Great Recession

    1024 Words  | 3 Pages

    However, prior to 2008, nearly everyone was blind to their impending doom; investors, bankers, government regulators, the general population, and even the chairman of the Federal Reserve, Alan Greenspan, a man who was considered the economic guru, was fooled into believing the prosperity America had been enjoying would last for the foreseeable future (“Rethinking” 20). By this time there had been only mild economic downturns or, at most, short periods of turmoil. Financial institutions and large corporations have grown accustomed to the decades of economic prosperity resulting from the post-war economic boom, long forgetting the lessons learned from the Great Depression (“Rethinking” 20). In fact, economists concluded that America had entered a new era of calm.

    Read More

  • The Influence of Interest Rates in our Lives

    739 Words  | 2 Pages

    Even though most of us may not realized it, interest rate actually play an important role in our everyday lives due to its great effect on the buying power. For instances, if the interest rate is higher, people tend to reduce their spending and rather save it in the deposit account due to the large interest that they can gained. However, if the interest rate is lower, they rather spend it than keeping it in the deposit account. The reason for this is because the ups and down of the interest rates have a significant impact on their personal income. Furthermore, since interest rate have a major impact on investment it is important for the investors to keep track on these interest rate’s trend before making any decision.

    Read More

  • Transforming Your Paper into a Presentation

    1045 Words  | 3 Pages

    Mishkin. F. C. (2009). The Financial Crisis and the Federal Reserve. NBER Macroeconomics Annual, 24, 495-508

    Read More

  • The Cost of Equity Capital and the Capital Asset Pricing Model

    1469 Words  | 3 Pages

    When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities

    Read More

  • Portfolio Analysis and Investment

    987 Words  | 2 Pages

    ...n efficient set that is on a straight line connecting the risk free rate to the most northwest point that we had identified previously. Now the risk averse investor has a lower risk for the same amount of return compared to the portfolios that did not include risk free lending. The combination is better because the points on the straight line are further northwest than the portfolios from the previous paragraph. Of course the lower the level of risk aversion the further toward the tangent the investor?s optimal portfolio moves.

    Read More

  • Essay On Capital Asset Pricing Model

    1344 Words  | 3 Pages

    Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).

    Read More

  • The Importance of Proper Asset Allocation

    1614 Words  | 4 Pages

    Asset allocation decisions made by an investor are considered more important than other decisions such as market timing or security selection. In the research provided by Hensel (1991), performance attribution is one of the main components when choosing the right assets in a portfolio. The impact of any investment decision can be measured by comparing its outcome with the outcome of some alternative decision. Furthermore, according to Hensel (1991), every investor has to incorporate the minimum-risk portfolio, which is a combination of securities or asset classes that reduces the uncertainty of future portfolio returns to a minimum.

    Read More

  • The Theoretical Rationale For The NPV Approach To Investment Appraisal

    1388 Words  | 3 Pages

    One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.

    Read More

  • The Global Financial Crisis and Its Impact

    1807 Words  | 4 Pages

    Bernanke, B. (2009, January 13). The Crisis and the Policy Response. Speech at the Stamp Lecture, London School of Economic, London, England. Retrieved from http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm

    Read More

  • Interest Rates On The Economy

    1462 Words  | 3 Pages

    Much like gross domestic product (GDP) interest rates branch into nominal and real. When one is familiarizing themselves with interest rates, being able to distinguish between a nominal and a real interest rates is cruci...

    Read More

  • Time Value Of Money

    1709 Words  | 4 Pages

    One might know that time is one of the most valuable assets in our lives. In the financial world the value of money is linked to time, primarily because investors expect progressive returns on their cash over periods of time, and they always compare the return from certain investments with the going or average returns in the market. Inflation on other hand erodes the purchasing power of money causing future value of one dollar to be less than the present value of a dollar. This paper will examine time value of money and the applications that determine successes or failures. An examination of the different vehicles that can be used to generate financial security for corporations and individuals will be provided. After defining the applications that generalize time value of money, an explanation will be offered regarding the components of interest rates by expanding on the concept that interest rate equates the future value of money with present value.

    Read More

  • Finance Course Reflection

    2036 Words  | 5 Pages

    Several financial statements have been prepared to describe the causes of this current financial failure. There are a variety of factors that has resulted in the explosion of this financial crisis. Downfall of the US housing market; highly benefited financial dealings and a low interest-rate promoting borrowings, have all contributed to the recession monetary market. Let us now consider these various reasons in a little detail.

    Read More

  • Financial Theories And Strategies

    1533 Words  | 4 Pages

    Using the Modern Portfolio Theory, overtime risk assets will provide a higher expected rate of return, as compensation to the investors for accepting a high risk. The high risk will eventually lower collecting asset classes to the portfolio, thus reducing the volatile risk, and increasing the expected rates of return. Furthermore the purpose of this theory is to develop the most optimal investments portfolio which would yield the highest rate of return while ascertaining the risk for the individual or corporate investor.

    Read More

  • Importance Of Bond Valuation

    1743 Words  | 4 Pages

    An investor uses bond valuation to determine what rate of return is required for an investment in a particular bond to be worthwhile because a bond’s par value and interest payments are fixed.

    Read More

More about Risk Free Rate Analysis

Open Document