In the context of the CAPM, what exactly is the Risk-free Rate (RFR)? is it the yield on a 10-year treasury, 3-mo t-bill, LIBOR? most of the problems just give you the RFR to plug in, but in a situation where you’re given a bunch of information I was just wondering which one you guys would use. Thanks in advance
This was discussed before. I think CFAI uses just a 3 month T-bill mainly. However, there was a discussion awhile back that the RFR should match the time horizon of an investment (something like that). So for a stock the RFR should equal the yield on a 30 yr T-bond which makes sense.
For generic RFR, Investopedia recommends 3m UST bill. Wikipedia also suggests T-bill rates. More specifically, in CAPM you’re plugging in the rate you’d receive on an investment in a risk-free bond, which sounds like a federal security to me. I’d think you could adjust this by the expected holding tenor. E.g. if the average equity holder is a 2.7 year investor, then use the 2.7y treasury rate. Even more specifically, for CFA L1 I don’t think you’ll need to care, they always just give you the rate. (Maybe you meant this post for General Discussion?)
Thanks Niblita75, Is the Return on Market (Rm) suppose to match the time horrizon as well, or maybe past 12 mo., or YTD? any ideas? I have been sort of applying the CAPM to the stocks that I’d actually owned, using an excel based formula (prob has errors), but from first blush it looks like the slightest change in Rm drives pretty big changes in the value of the stock.
DarienHacker Wrote: ------------------------------------------------------- > For generic RFR, Investopedia recommends 3m UST > bill. Wikipedia also suggests T-bill rates. > > More specifically, in CAPM you’re plugging in the > rate you’d receive on an investment in a risk-free > bond, which sounds like a federal security to me. > I’d think you could adjust this by the expected > holding tenor. E.g. if the average equity holder > is a 2.7 year investor, then use the 2.7y treasury > rate. > > Even more specifically, for CFA L1 I don’t think > you’ll need to care, they always just give you the > rate. (Maybe you meant this post for General > Discussion?) Thanks Darien, that makes a lot of sense. I guess this may be a general discussion item but I do remember a practice problem once that gave the 10 year and the 3 mo and inputing the wrong RFR screwed up your answer…so maybe this thread could be helpful. You’re right in that I don’t ever remember the RFR being anything but a given on the actual exam.
You have to be careful here, I do recall an instance on one of the CFAI practice exams where there was a CAPM question and they DID NOT use the tbill rate as the RFR. One of the answer choices was based on the Tbill rate and it was wrong, as Niblita75 states RFR should match the time horizon. For what its worth, on the actual exam (from what I remember) the CAPM questions were pretty straight forward. Dubs
If you plugged in the return on the market over say 2 years, you will end up with a required return for the stock over a 2 year period. So its really up to you (you need to account for the time horizon in your beta calculation).
clos83, true, and your calculation of beta will vary things substantially too. There are numerous ways to estimate these inputs, which is one of the model’s weaknesses when it comes to actual application. At Level II you’ll analyze these shortcomings and be introduced to some alternatives, including the Single Index Model and APT.
hiredguns1 Wrote: ------------------------------------------------------- > clos83, true, and your calculation of beta will > vary things substantially too. There are numerous > ways to estimate these inputs, which is one of the > model’s weaknesses when it comes to actual > application. At Level II you’ll analyze these > shortcomings and be introduced to some > alternatives, including the Single Index Model and > APT. hiredguns- Thanks for your reply, although I just got that falling motion feeling in the pit of my stomach when you mentioned level 2:)…I haven’t received the text books yet but seems like some interesting topics in stock valuation I look forward to learning about.
TheDubs Wrote: ------------------------------------------------------- >, as > Niblita75 states RFR should match the time > horizon. The time horizon of what? The holding period of the stocks? The duration of the stocks? The average length of time money will be in the portfolio? CAPM doesn’t really deal with any of that. One of the many criticisms of CAPM is that there is no universal risk-free rate that is applicable and fluctuations in the rate should somehow change the market portfolio in nearly predictable ways. There is no empirical evidence that occurs.
My stating “time horizon” wasn’t clear. I was thinking that since a stocks duration is theoretically infinite you would use the longest maturity bond. However, it is more like you pick whatever risk free rate floats your boat. I do remember that a CFAI question (not sure though it could be Schweser) used something other than the t-bill rate and thats how this got started on the L1 forum.
Joey, I was waiting for your to come correct me :). I am not arguing the downfalls or “criticisms” of the CAPM, and I know there is no universal risk free rate. I was just reffering to one specific question I saw on the CFAI practice exams. I don’t remember the exact numbers that were used (I could probably find it if I dug) but, in the specifc question, because the holding period of the stocks was longer term they did not use the Tbill rate as the RFR, they used the rate on a longer term treasury security. In a question of that nature how would you differentiate between which rate to use?
^^ A practice exam given from CFAI wanted you to use the 10 year note for the RFR. If you used the 3 mo Bill you got the question wrong. I can’t remember the exact context of that question though. I do remember everybody complaining, because we all missed it. EDIT: Didn’t see TheDubs answer before I posted
I think we had to caclulate beta and needed to use the 10 year to get the correct answer. We were only given 3 mo and 10 yr and the investment time horizon was “long-term”.
Thanks mwvt9, that was the one I was thinking of.