Is the Risk-Free Rate Really “Risk-Free”? Why U.S. Treasuries Could Trade Like Meme Stocks

You'll learn about the Risk-Free Rate in this tutorial, including why the name is deceptive, and how it's 100% possible to lose money on "safe" government bonds (and also earn far above the stated yield).
Table of Contents:
0:00 Introduction
3:58 What is the Risk-Free Rate?
5:53 Interest-Rate Risk
13:39 Currency Risk
16:51 Inflation Risk
19:44 Recap and Summary
Files & Resources:
youtube-breakingintowallstree...
youtube-breakingintowallstree...
KEY POINTS:
Although the Risk-Free Rate used in valuation and DCF analysis is based on government bonds such as 10-year U.S. Treasuries, these bonds are not actually "risk free."
Instead, the bonds are simply assumed to be free of "default risk," i.e., there is no chance the government will fail to repay them (in theory).
However, they do have other types of risk, such as interest-rate risk, currency risk, and inflation risk.
As a result, it's very possible to buy a 10-year U.S. Treasury and earn an annualized amount much different from the stated yield, such as 3-4%.
What is the Risk-Free Rate?
It is used in valuations to calculate the Discount Rate, normally the Cost of Equity or WACC. The basic idea is to take what you could earn in “risk-free” government bonds, add the additional return offered by the stock market, and then multiply by a factor representing this company’s volatility relative to the market as a whole.
The "risk-free rate" is usually based on the 10-year government bond yield of the company's country, and it sets the baseline for the returns expectations on other types of securities, such as stocks and corporate bonds (they should have higher expected returns because they are riskier).
Interest-Rate Risk
If you hold a government bond to maturity, yes, you should receive interest payments and the full principal back upon maturity.
However, if you sell before then, you might lose money because interest rates and prevailing yields on similar bonds might change.
For example, if the 10-year yield goes from 1.0% to 3.5% over 2 years (what happened in 2020 - 2022), a 10-year bond with a 1.0% coupon will lose 17% of its value, and if you sell it early, you'll lose money.
This is much more of an issue for longer-term bonds, such as 10- and 20-year ones, than it is for short-term ones (6-months to 2 years). It's also more of a problem when interest rates change rapidly in a short period.
Currency Risk
If you buy a foreign government bond, you also assume some currency risk because the exchange rate between your currency and the other one might change.
For example, the USD was worth just above ~100 JPY in 2020, but in 2022, it zoomed up to almost 150 JPY (meaning the JPY weakened by a huge amount against the dollar). If JPY-based investors had bought 10-year U.S. Treasuries at the end of 2020 and sold them at the end of 2022, they would have earned money despite the rising interest rates - because the JPY fell by even more than bond prices!
Inflation Risk
Finally, even if you earn the full interest payments and the bond principal back upon maturity, you might still lose money in real terms if the inflation rate exceeds the bond yield.
This is not an issue when inflation is low and stable (e.g., 1-2% per year over long stretches), but when it goes up to 5-10% or more, it becomes a problem.
When you combine above-average inflation with the rapid increase in interest rates in 2022, investors in long-term U.S. Treasuries lost a high percentage... and even if they hold until maturity, inflation will dampen their returns.

[@financialmodeling]

Files & Resources / Downloads: youtube-breakingintowallstreet-com.s3.amazonaws.com/Risk-Free-Rate.xlsx youtube-breakingintowallstreet-com.s3.amazonaws.com/Risk-Free-Rate-Slides.pdf For the Table of Contents and the written summary, please see the video description under "Show More."

[@Romulus1001]

This video perfectly illustrates how SVB's collapse can be attributed (in part) to its bond portfolio's exposure to interest rate risk. Maybe you should create a video that explains SVB's collapse and how the principles here coincide with today's events.

[@financialmodeling]

Yup, that's true. We published an article about it today: mergersandinquisitions.com/silicon-valley-bank/ And I may create a video on this AFS vs. HTM issue and bank regulatory capital next week and use it to explain more about SVB.

[@dbsk06]

Great refresher thank you

[@dbsk06]

Risk free rate refers to only default risk

[@financialmodeling]

Thanks for watching!

[@jayliu645]

Am I reading this right? At the end of 2022-12-31, you will get ¥107,993; if the Yen strengthens to USD:JPY to 80, this will be translated into $1,349.91. So, compared with the original investment of $1000, how did you lose money? Don't you want to buy a foreign investment when your home currency is strong and sell when your home currency is weak to maximize the exchange rate effect?

[@financialmodeling]

If the Yen strengthens, USD are now worth less. If the USD:JPY falls to 80, meaning the JPY has strengthened, the final bond price is only 66,150 when converted back to JPY. I think you reversed something. Buying when the home currency is strong and selling when it's weak is what we demonstrated here - an FX rate of 130 means the JPY is much weaker. So the Japanese investors benefited from buying UST when the FX rate was lower (100), meaning a stronger JPY, and selling when the FX rate was higher (130), meaning a weaker JPY.