Choosing Between 10-Year and 30-Year Treasury Yields as a Risk-Free Rate
The choice between using the 10-year and 30-year Treasury yields as an estimate of the risk-free rate depends on the specific needs of your financial analysis. Both yields provide valuable insights but serve different purposes within various economic horizons.
Understanding the 10-Year Treasury Yield
The 10-year Treasury yield is widely used in financial models and valuations due to its balance between liquidity and market expectations. Reflecting medium-term market expectations, it is typically more liquid and has a larger trading volume, making it a preferred choice for short- to medium-term financial analyses. This yield is particularly useful for scenarios where the investment horizon is within the 10-year to 20-year range, aligning well with the duration of many financial assets and contracts.
Understanding the 30-Year Treasury Yield
On the other hand, the 30-year Treasury yield offers a longer-term outlook. This yield is less commonly used in short-term financial analyses but is invaluable for long-term projects or investments that span several decades. Due to its long-term nature, it may be more influenced by factors such as long-term inflation expectations and demographic trends, which can be crucial for long-term financial planning.
Choosing the Appropriate Yield
For most short- to medium-term financial analyses, the 10-year Treasury yield is typically preferred as a better estimate of the risk-free rate. This is because it strikes a balance between liquidity, market expectations, and relevance to many financial instruments. However, for very long-term forecasts or investment horizons, the 30-year Treasury yield may be more appropriate due to its alignment with long-term economic trends and expectations.
Inflation and Market Interest Rates
Current inflation standing at 3% and the rising wage trend suggest that market interest rates for USD, even without Federal Reserve (Fed) intervention, will likely increase in the coming years. Taking a simplistic view, market interest rates may increase to around 5%, essentially adding a buffer over the inflation rate. For the 30-year Treasury, this higher inflationary outlook may result in lower volatility, with yields potentially staying around 4%, assuming no significant trade wars and a constant money supply growth rate.
The Concept of the Risk-Free Rate
The risk-free rate is a theoretical construct used in financial modeling. While it is an ideal concept, no true risk-free rate exists in the real world, just as it is physically impossible to reach absolute zero or have a frictionless surface. Despite this, the ideal construct of the risk-free rate is crucial for theoretical and practical financial analyses. The choice of risk-free rate does not reflect the actual risk of any instrument or how that risk is defined; rather, it is about finding the number that provides the most accurate results in your specific application.
Conclusion
Choosing between the 10-year and 30-year Treasury yields as a risk-free rate depends on the specific context of your financial analysis. For short- to medium-term financial analyses, the 10-year yield is generally preferred due to its balance between liquidity and market expectations. For long-term analyses, the 30-year yield may be more appropriate. Understanding these nuances can significantly enhance the accuracy and relevance of your financial models and forecasts.