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The Capital Asset Pricing Model’S Risk-Free Rate

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  • Sandip Mukherji

Abstract

The risk-free rate is an important input in one of the most widely used finance models: the Capital Asset Pricing Model. Academics and practitioners tend to use either short-term Treasury bills or long-term Treasury bonds as the risk-free security without empirical justification. This study investigates the market and inflation risks of Treasury securities with different maturities over different investment horizons. The results show that mean real returns, volatility, and market and inflation risks, of Treasury securities increase with the maturity period. Only Treasury bills do not have any market risk for 1- and 5-year periods, and they have the lowest market risk over 10 years. Although Treasury securities of all maturities have significant inflation risk, Treasury bills have the lowest inflation risk over all three horizons. Further, the inflation beta and explanatory power of inflation for real Treasury bill returns decline with the investment horizon. Over 10 years, inflation and market risks explain only 13% of variations in real Treasury bill returns, compared to 20% of intermediate government bond returns, and 23% of long government bond returns. These findings indicate that Treasury bills are better proxies for the risk-free rate than longer-term Treasury securities regardless of the investment horizon.

Suggested Citation

  • Sandip Mukherji, 2011. "The Capital Asset Pricing Model’S Risk-Free Rate," The International Journal of Business and Finance Research, The Institute for Business and Finance Research, vol. 5(2), pages 75-83.
    • Handle: RePEc:ibf:ijbfre:v:5:y:2011:i:2:p:75-83
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    References listed on IDEAS

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    Cited by:

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    2. Chia, Rui Ming Daryl & Lim, Kai Jie Shawn, 2012. "The Attenuation of Idiosyncratic Risk under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market," MPRA Paper 41455, University Library of Munich, Germany.
    3. Benedict J. Drasch & Gilbert Fridgen & Lukas Häfner, 2020. "Demand response through automated air conditioning in commercial buildings—a data-driven approach," Business Research, Springer;German Academic Association for Business Research, vol. 13(3), pages 1491-1525, November.
    4. Magomet Yandiev, 2021. "Risk-Free Rate in the Covid-19 Pandemic: Application Mistakes and Conclusions for Traders," Papers 2111.07075, arXiv.org.
    5. Bettina Freitag & Lukas Häfner & Verena Pfeuffer & Jochen Übelhör, 2020. "Evaluating investments in flexible on-demand production capacity: a real options approach," Business Research, Springer;German Academic Association for Business Research, vol. 13(1), pages 133-161, April.

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    More about this item

    Keywords

    Risk-free rate; Capital Asset Pricing Model; investment horizon;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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