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As we learned in Chapter 1, interest amounts to “rent” on borrowed money, or the price of money. Thus, rRF is the price of money to a riskless borrower. We also learned that the risk-free rate as measured by the rate on U.S. Treasury securities is called the nominal, or quoted, rate, and it consists of two elements: (1) a real inflationfree rate of return, r*, and (2) an inflation premium, IP, equal to the anticipated rate of inflation.15 Thus, rRF
r*  IP. The real rate on long-term Treasury bonds has historically ranged from 2 to 4 percent, with a mean of about 3 percent. Therefore, if no inflation were expected, long-term Treasury bonds would yield about 3 percent. However, as the expected rate of inflation increases, a premium must be added to the real risk-free rate of return to compensate investors for the loss of purchasing power that results from inflation. Therefore, the 6 percent rRF shown in Figure 3-12 might be thought of as consisting of a 3 percent real risk-free rate of return plus a 3 percent inflation premium: rRF
r*  IP
3%  3%
6%.

If the expected inflation rate rose by 2 percent, to 3% 2%
5%, this would cause rRF to rise to 8 percent. Such a change is shown in Figure 3-13. Notice that under the CAPM,the increase in rRF leads to an equal increase in the rate of returnonall risky assets, because the same inflation premium is built into the required rate of return of both riskless and risky assets.16 For example, the rate of return on an average stock, rM, increases from 11 to 13 percent. Other risky securities’ returns also rise by two percentage points.

The discussion above also applies to any change in the nominal risk-free interest rate, whether it is caused by a change in expected inflation or in the real interest rate. The key point to remember is that a change in rRF will not necessarily cause a change in the market risk premium, which is the required return on the market, rM, minus the risk-free rate, rRF. In other words, as rRF changes, so may the required return on the
market, keeping the market risk premium stable. Think of a sailboat floating in a harbor. The distance from the ocean floor to the ocean surface is like the risk-free rate, and it moves up and down with the tides. The distance from the top of the ship’s mast to the ocean floor is like the required market return: it, too, moves up and down with the tides. But the distance from the mast-top to the ocean surface is like the market risk premium—it generally stays the same, even though tides move the ship up and down. In other words, a change in the risk-free rate also causes a change in the required market return, rM, resulting in a relatively stable market risk premium, rM  rRF.

Taken From : Five-Minute MBA – Corporate Finance

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