Which Treasury yield should you use as the risk-free rate?

Match the maturity to the period you are measuring. For a one-year return or a trade held for months, a short-term Treasury bill yield is the usual choice. For valuing a long stream of cash flows, analysts often use a longer Treasury yield. Whichever you choose, use the same one when comparing results.

Is the risk-free rate really free of risk?

It is free of default risk in dollar terms, since the Treasury is treated as certain to pay. It still carries inflation risk, because the dollars returned may buy less, and reinvestment risk, because the rate on the next bill may be lower when the current one matures.

Risk-Free Rate: The Treasury Yield Other Returns Are Measured Against

Every business day the Treasury posts its yield tables. The short end of that table, the bills maturing in weeks or months, is what most of finance means when it says “risk-free rate,” and it’s a more demanding benchmark than it sounds. A strategy that trails bills over the same stretch has carried risk and been paid nothing for it.

What the rate earns in dollars

Start with the plain version. $10,000 in Treasury bills at a hypothetical 4% for one year earns $400, with no stock picking and no stops to manage. That $400 is the floor. Any riskier use of the same $10,000 has to clear it first.

Excess return and the Sharpe ratio

Subtract the risk-free rate from a portfolio’s return and what remains is excess return, the part that came from taking risk. Divide it by volatility. The result is the Sharpe ratio.

Put a hypothetical $50,000 behind it. The portfolio made $5,000; bills would have made $2,000. Risk earned the other $3,000. Whether $3,000 was a fair price for sitting through the swings that a 15% volatility implies is the question the Sharpe ratio is built to frame, and two portfolios with the same 10% return can score very differently once their volatility is counted.

Now a second portfolio. It also returns 10%, with 30% volatility against the same 4% rate, and scores 6 / 30 = 0.2, half the reward per unit of risk for an identical headline return.

Why it matters on margin

The rate reaches traders from another direction. Brokers set margin rates as a spread over a benchmark. Benchmarks track short-term rates. So when bill yields climb, margin interest usually climbs too, and a leveraged trade now has to clear the cost of the loan plus the return you passed up on bills, a double hurdle that gets taller at exactly the time a safe alternative is paying the most. The column on the T-bill hurdle makes that case in full.

Why stock prices care

The same rate sits at the bottom of every discount rate. A payment of $100 due in one year is worth what you would have to set aside today, at the risk-free rate, to end up with $100.

Nothing about the payment changed. The higher rate alone knocked $1.81 off its value today, and for a stock whose cash flows stretch many years out the effect compounds with every year of distance, which is why growth companies with profits far in the future tend to react hardest when yields jump.

Where you see it

Treasury rate tables are the direct source. Economic releases that report market yields repeat them. It also sits, usually unstated, inside other numbers: the discount rate in a valuation model, the carrying cost in an option price, the spread a bank earns over its funding. A bank’s net interest margin moves partly because this rate moves, which makes the bill yield a quiet input to far more headlines than the ones about Treasury auctions.

What people get wrong

Comparing a return over three years against a single day’s bill yield, when the rate for the whole period may have moved a long way and the fair comparison is what rolling bills over that same stretch would actually have earned, one maturity after another.
Calling a long Treasury bond risk-free over a few months. Its price can fall.
Reporting a strategy’s return without subtracting the rate at all.
Leaving it out of the investing vs trading decision. Active trading has to beat bills and pay for your time.

The Sharpe ratio uses the risk-free rate directly. The equity risk premium is the excess return investors expect from stocks over it. The economics section follows the policy decisions that push short-term yields up and down.