3.2.4. Risk-free asset

The risk-free asset is one of the components of the CAPM model. It is used as the minimum return an investor can expect if he or she does not want to take any risk in an investment. This concept implies that an investor can expect to not lose any of his or her investment and interest in whichever situation. Naturally, in the real world there is not an asset that is completely risk-free, so in practice the risk-free asset usually refers to an asset with the lowest level of risk that is available to the investor.

The treasury bills or government bonds issued by a country with a high credit rating are typically used as a reference for the risk-free asset.

The chart below presents the evolution of the 10-year Treasury bonds years USA, Germany and Portugal. The Germans T-bonds have consistently the lowest return, reason for being often assumed as the reference risk-free asset, although American investors usually use USA T-bonds.

Notice how the German T-bonds have a rate of return the below 1%. It is hardly expectable that the returns of the T-bonds would remain at such level for 10-years, hence you may decide to use an average rather than an instant T-bond value.

Investor profile

The cost of capital perceived by one individual is inseparable from who holds it, profile and restrictions. Due to geographical, legal, and economic policies constraints, one cannot say that all investors have the same access to the worldwide existing financial assets. It is easy to identify several geographies where local investors face restrictions on accessing foreign financial markets, consequence of limitations on the movement of capital, either due to legal regulations or due to currency liquidity issues. The difficulty in converting local currencies into international currencies can have a deterrent effect for the associated costs. An asset that can be regarded as without risk for an investor in the United States or in Europe, may not be easily accessible to an investor from other locations. For the latter, the risk-free asset reference must be that of a local financial asset.

Determining the cost of capital must consider the profile of the investor.

Time horizon

Choosing the reference risk-free asset should consider the time frame of the investment. If the analysis of projects usually comprise a timeframe of 3 years, you should use risk-free reference with an approximate time. While valuing a company using a simple perpetuity of free cash-flows or a Net Present Value with an unrestricted residual value, the risk-reference should have a time horizon of at least 10 years.

Next Section: 3.2.5. Beta