Investments, tenth edition

  The Risk-Free Rate Revisited 

 At the outset of this chapter we put forward a simple view of the real and nominal risk-

free rate, where we were not very explicit about investment horizon. But as a general 

rule, the maturity of the risk-free rate should match the investment horizon. Investors 

with long maturities will view the rate on long-term safe bonds as providing their bench-

mark risk-free rate. Interest rates generally vary with maturity and, surely, inflation is 

more difficult to predict over longer horizons. Thus inflation risk becomes more potent 

with maturity. 

 It is important to realize that the risk premium on risky assets is a  real   quantity.  The 

expected rate on a risky asset equals the risk-free rate plus a risk premium. That risk pre-

mium is incremental to the risk-free rate and makes for the same  incremental   addition, 

whether we state the risk-free rate in real or nominal terms. 

 An investor views the  real  rate for each maturity as the benchmark for investments of 

that maturity, and hence a real risky rate should be displayed as a real risk-free rate plus 

 Figure 5.12 

Wealth indexes of selected outcomes of large stock 

portfolios and the average T-bill portfolio. Inset: Focus on worst, 

1%, and 5% outcomes versus bills.  

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Worst

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Median

T-Bills

Years

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ealth Index

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a risk premium. Even default-free nominal rates on long-maturity Treasury bonds may 

embody a risk premium due to uncertainty about future inflation and interest rates. 

 Enter TIPS, the Treasury bond that promises investors an inflation-indexed real rate for 

a desired maturity. Now we can think of the expected real rate on a risky investment of a 

given maturity as the rate on the same-maturity TIPS bond plus a risk premium. 

 The existence of both nominal Treasuries and TIPS also has informational value. The 

difference in the expected rates on these bonds is called the  forward  rate of inflation, which 

includes both the  expected  rate and the appropriate risk premium. 

 Why then do we see excess returns usually stated relative to one-month T-bill rates? 

This is because most discussions refer to short-term investments. To seriously consider a 

long-term investment, however, we must account for the relevant real, risk-free rate.