Risk-free rate: meaning and how it is chosen in India

Almost every valuation formula starts with one number: the risk-free rate. It is the base return you could earn without taking credit risk. This page explains what the risk-free rate means, how it is chosen in India and why it moves markets.

Quick answer

The risk-free rate is the return on an investment that is considered to have almost no risk of default. In practice, it is usually the yield on government securities in the investor's home currency, such as the 10-year Government of India bond yield for long-term valuations. It is the starting point for models like CAPM and for discount rates in valuation.

Key takeaways

• It is the return on an asset with almost no default risk.
• In India, government bond yields are used as the proxy.
• The 10-year G-sec yield is common for long-term valuation.
• It is the base for CAPM and the cost of equity.
• When it rises, valuations of shares and bonds tend to fall.

What is the risk-free rate?

In theory, a risk-free asset pays a known return with no chance of default. No investment is truly free of all risk, but bonds issued by a government in its own currency come closest, because the government can always raise taxes or create money to repay.

So investors use government bond yields as a stand-in. Any other investment, such as a company bond or a share, should offer a higher return to make up for its extra risk.

How is it chosen in India?

For valuing shares, analysts usually use the 10-year government bond yield, since shares are long-term assets. The idea is to match the time period of the cash flows being valued with the maturity of the bond.

The yield changes every day in the market. Analysts often use the current yield, though some use an average over a period to smooth out short-term swings.

Where is it used?

In CAPM, the cost of equity equals the risk-free rate plus beta times the equity risk premium. In DCF valuation, it feeds into the discount rate. In option pricing models like Black-Scholes, it is one of the five inputs.

It also forms a base for comparing investments. If government bonds pay a certain yield, a fixed deposit, a corporate bond or a share should be judged against that base.

Why does it move markets?

When the risk-free rate rises, investors can earn more from safe bonds, so they demand higher returns from riskier assets. This lowers the value of future cash flows, which tends to push share prices down, especially for companies whose profits are far in the future.

When it falls, the opposite tends to happen. This is one reason RBI policy decisions and bond yield movements are watched so closely by equity investors.

Points to remember

A government bond is free of default risk only in its own currency. It still carries interest rate risk, since its price falls when yields rise, and inflation risk. The term 'risk-free' is a simplification used for modelling.

In short, the risk-free rate is the base return in finance. Knowing how it is chosen and how it moves helps you understand valuations and market reactions to interest rate changes.

Frequently Asked Questions