When given short term t-bills and long term govt bond rate which should we use as the risk free rate? Will it always be the same or will it depend on the model we are using?
thanks
it should match with the tenure of the cash flows. if you have long term cash flows, long term govt bond rate would be risk free rate
For exam purposes, they will give you only one risk free rate to use.
For practical purposes, you should use either use the one risk free rate that matches the duration of cash flows (which isn’t as easy as it sounds for non-fixed income securities), or the spot risk free rate that matches every duration of cash flow, simillar to pricing a bond using spot rates.
^I don’t think that’s quite true. There was a practice set on the website that gave you the LT gov’t bond yield, ST gov’t bond yield and treasury rate (?, or some other rate). It said to calculate the rate of return using the bond yield model plus risk premium approach and therefore, you use the LT gov’t bond yield.
So I think it depends on the model being used.
The bond yield approach builds on top of the firm’s cost of debt with an equity risk premium. So no treasuries are used in this case.
But generally, equity should be valued using long term risk free rates (typically the YTM of more than 8 year T-bonds) if the security in question is a going concern. Which would be the defualt and automatic case, at least for exam purposes. This is not the most accurate way, but more accurate than using shorter term RfRs.
So I read using the short term rate biases the equity risk premium in a positive direction. But when doing the candidate resources questions in equity the fama french gives s.t. t-bill rate and l.t bond rate and the answer uses the s.t. t-bill rate as the rfr. Seems to be contradictory information? Thoughts?
It’s wrong.
which is wrong?
Using a short term risk free rate as the opportunity cost in the risk premium build up approach for all cash flows in equity valuation.