Hello guys,
Which risk-free rate should we use while calculating the cost of equity by CAPM?- The short-term govt. bond yield? or the long term govt. bond yield? I am doing the Topic Tests on equity of the CFA website and I have encountered two sets where two different yields (short and long) were used. Unfortunately they don’t explain in the answers why they used short term in one and long term in the other.
Could somebody please clarify if the CFA books mention somewhere which is to be used and when?
I would use the long-term rate. Not sure when to use the short-term one.
I work in M&A and we always use the long-term rate too. But in Topic Test 6 of Equity of the CFA website, one of the answers is calculated using the short-term rate. (In the question both short and long term rates were given and the answer used the short term). I am confused now
Can you indicate the topic test exact name? I will check it.
Yes. Topic Test “Equity-Western” used short term rates and Topic Test “Rivera” used the long-term rates. (They should be the same names unless in my account I have them ordered differently than yours)
Capm uses long term and all other multifactor model fama-french,carhart,psm use short term.
Somewhere is stated that depends on invest horizon. I also have noticed this in CFAI portal tests.
In the “Western” topic test question #2 it is required to calculate the required return on equity using Fama-French model, not the CAPM. I must tell you that FF model uses short-term risk free rate because the researchers who created the model (Eugene Fama and Kenneth French) found useful using short-term risk free rate in their study to explain returns on equity.
This is the only model that uses short-term RF rate, memorize it!
PD: CAPM should use long-term risk-free rates.
I was almost sure you were gonna say they were short sighted.
And I suppose that Pastor-Stambaugh model, which is extended FF model also uses short term RF?
Oooh good info here. Thanks abeshak and Harro!
CAPM, long term RFR
Multifactor model, short term RFR
Of course now that this is in my head there will only be one rate to choose from on the exam.
Correct, Pastor-S model adjusts the model for liquidity only. It also uses short-term RF.
Thanks for calling that.
lol, they were smart people tho!
Thank you for claryfing this. Any additional info is strongly appreciated, especially now.
Myron Scholes and Robert Merton are smart too, but LTCM just happened…
Being smart has nothing to do with being greedy and working in an enviroment that does not control conflict of interests.
Using excessive leverage in derivatives in the sake of profit was just that, the seek of profit, not capital preservation. I would not invest all my money there!
I would say that were able to predict all factors unless Russian (Slavish) mentality…LOL! Psychology screwed ‘em.
Speaking of psychology, I think time is ripe to create behavioral models as opposed to fundamental. There is just too much sentiment and irrational behavior in the markets and one cant rely on a naive model such as CAPM.
I am quite sure that such models will be crucial part of CFAI curriculum for less than a decade. IMHO, fundamental models are school relic and fewer based in fact.
Look at the BSM of mentioned duo (I have not found that third was included in LTCM). It’s bassed on irational assumptions. CAPM as well. All investors can borrow by the risk-free rate, all investments are infinitely divisible, etc… On which market such conditions exist?