THE CAPITAL ASSET PRICING MODEL’S RISK-FREE RATE

Sandip Mukherji

The International Journal of Business and Finance Research, 2011, vol. 5, issue 2, 75-83

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.

Keywords: Risk-free rate; Capital Asset Pricing Model; investment horizon (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (5)

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