How to Choose Risk-Free Rate in CAPM

Choosing the right risk-free rate in the Capital Asset Pricing Model (CAPM) is crucial for accurate investment analysis and decision-making. A risk-free rate is typically represented by the yield on government securities, such as Treasury bonds, which are considered free of default risk. However, selecting the appropriate rate involves considering various factors, including the time horizon of the investment, inflation expectations, and market conditions. This article explores different methodologies for selecting the risk-free rate, the implications of using various rates, and real-world applications to provide a comprehensive understanding of this vital component in financial modeling. In practice, investors often face dilemmas regarding which securities to use as benchmarks and how to adjust rates for specific circumstances. This article aims to demystify these decisions, offering insights and frameworks to guide investors through the complexities of determining an accurate risk-free rate in CAPM analysis.