Risk-Free Rate Types

To determine which risk-free rate to use is the more appropriate between the current government interest rate and the historical average, there are some elements we have to consider.

Periodic

The longer the period we take, the lesser the effect resulting from any extreme economic situation it is. It is easy to imagine that if there is an economic crisis, like the PIIGS [Portugal, Ireland, Italy, Greece and Spain], the interest rate and coupon rate are high in the times they are in trouble. If we cannot take a stable government interest rate, it would not be effective to evaluate market premiums and derive WACC. In other words, government interest is highly subject to the economic situation for the time being. Slight effects will only take place for the historical average as the extreme value is shared amongst the historical values.

Predictive

As historical average is the figure calculated based on the past, it reflects how the risk free rate formed. The historical average helps much in explaining the trend in the past for the economy. It can clarify the correlations between different elements during economic downturn or upturn.

However, it is not advised when it is used in forecasting and making prediction. Situations change from time to time and trends in the past do not mean it will recur. On the contrary, the interest rate of the government is updated from time to time for evaluating the current default risk and economic situation.

To determine which risk-free rate to use is the more appropriate between the current government interest rate and the historical average, there are some elements we have to consider.

Periodic

The longer the period we take, the lesser the effect resulting from any extreme economic situation it is. It is easy to imagine that if there is an economic crisis, like the PIIGS