- We'll get back to Beta in just a moment,
but let's spend a minute talking about the risk-free rate,
which is another important element
in the capital asset pricing model.
Let's imagine that I've been asked to loan $1
to the most trustworthy organization on Earth.
I don't know who that is, but let's just imagine them.
The most trustworthy organization on Earth.
They are going to pay me back for sure.
Now what interest rate would I charge on this loan
to the most trustworthy organization?
That's the risk-free loan we're talking about.
Well the interest rate is not going to be zero
for a couple of reasons.
First of all, there might be some expected inflation.
Price levels might be expected to go up 2%, 3%, 4%, 5%
over the next year.
So I have to build at least the expected inflation rate
into the interest rate that I'm going to charge.
In addition, there is the time value of money.
Now let me explain this by referencing
the time value of candy.
I can illustrate this with a fun experiment
involving one of my grandchildren.
Let's say that I make the following proposal
to my grandchild.
I've got a piece of candy here.
Would you like this piece of candy now
or would you like one piece of candy a year from now?
What would any rational child do
or any irrational child for that matter?
They'll say, I want the candy now.
Any child understands the time value of candy.
A piece of candy now is worth more than a promised piece
of candy one year from now.
It's the same thing with money.
A dollar now is worth more than a dollar a year from now.
So if I'm going to lend you a dollar now,
you have better pay me back a little bit more
than a dollar one year from now,
even if there's no risk.
So the risk-free rate on an investment is going
to be a combination of two things;
the general time value of money, and expected inflation.
The risk-free rate is not always the same over time,
and it's not always the same in each individual country,
but over the last 50, 60, 70 years worldwide,
the risk-free rate has been about 5%.
Just an approximation.
When inflation is low, the risk-free rate is going
to be less than 5%.
When inflation is high, the risk-free rate is going
to be more than 5%.
So when you think about the risk-free rate,
I just want you to have that number in your brain.
5% is a good approximation over time of the risk-free rate.
5%.