Question

a. What type of problems exists with the estimation of the risk-free rate of return?

b. Why is it important to be mindful of the assumptions underlying use of the capital asset pricing model?

Please also provide reference if possible.

Thanks in advance.

Answer 1

a. The problems that arise are:

1. The risk free rate of return that we use is the T-bill rate. The T-bill rates keep changing every moment and is difficult to use a constant risk free rate of return

2. The risk free rate considers the rate just to cover inflation (price rise). Forecasting the accurate inflation based on consumer price index is difficult

3. Most of Europe have negative bond yields and the problem is whether we use the negative return as the risk free rate when yields turn negative or do we take the risk free rate as zero.

b. The capital asset pricing model is also an estimation and hence its important to keep in mind the assumptions because:

1. The beta of the company will change as per the risk profile of the business. If we use a rate of return calculated by CAPM with lower risk and use it to evaluate a high risk project, then we may end up accepting a unprofitable project

2. The market return is assumed to be a constant and is the historical market return. However, the actual market return and risk premium are constantly changing and this expected return in the CAPM will not be a constant in actual

3.The third assumption is the assumption of the constant risk free rate which was discussed earlier and the need to keep this in mind as well.