The risk free rate is one of the most basic concepts that you need to know. This rate is the theoretical return of an investment with no risk. In theory, it is easy to define, but in practice it becomes slightly harder. Since all companies have default risk associated with them, we can’t use any of their bonds as a risk-free measure. This leaves with government debt. Typical practice is to use the yield from a ten-year US treasury note as the risk-free rate.
This works fine and dandy as long as you are valuing something in the United States. But with emerging markets such a hot topic now, what rate should you use in those cases? The best way to approach this scenario, is to apply a premium to a risk free rate. This premium is the default risk of the country as a whole. For example, you take the 10 year treasury yield and add to it the default risk of the country, and that would be the risk free rate for that country.
H ow do you figure out what premium to add? That is also straightforward to figure out. Almost every country is going to have some sort of bonds/debt outstanding. The yield on a ten year bond (same maturity as the risk free rate), or what ever the closest bond is to ten year, is your premium. This yield signifies how risky the country’s government is; this yield is the rate you need to achieve to invest in that country. By adding it to the US risk free rate you get the risk free rate for the country.
The risk free rate is very important. It is the lowest rate you should demand for any investment you make. Since all investments carry some risk with them, your investment return has to be greater than the risk free rate. The amount it has to be greater than is the topic for the next post.