How is the risk-free rate determined when calculating market risk premium?

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A:

The risk-free rate is the rate of return of an investment with no risk of loss. Most often, either the current Treasury bill, or T-bill, rate or long-term government bond yield are used as the risk-free rate. T-bills are considered nearly free of default risk because they are fully backed by the U.S. government.

The market risk premium is the difference between the expected return on a portfolio minus the risk-free rate. The market risk premium is a component of the capital asset pricing model, or CAPM, which describes the relationship between risk and return. The risk-free rate is further important in the pricing of bonds, as bond prices are often quoted as the difference between the bond’s rate and the risk-free rate.

The risk-free rate is hypothetical, as every investment has some type of risk associated with it. However, T-bills are the closest investment possible to being risk-free for a couple of reasons. The U.S. government has never defaulted on its debt obligations, even in times of severe economic stress. T-bills are short-term securities that mature in one year or less, usually issued in denominations of $1,000. T-bills are auctioned at or below their par value, and investors are paid the par value of the security upon maturity.

Since T-bills are paid at their par value and do not have interest rate payments, there is no interest rate risk. Anyone is free to buy T-bills at weekly Treasury auctions. They are a very simple instrument for investors to understand. T-bills are issued by the government to fund the national debt. Yields on long-term government bonds are sometimes used as the risk-free rate depending on the investment being analyzed.


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