JAMES WESTON: Hi. Welcome back to Finance for Non-Finance Professionals. This week, we're talking about the cost of capital, and our discussion of the cost of capital is going to start at the very base, what we're going to call the risk-free rate. And that's what we're going to talk about in this lesson. If you think about, what is the safest possible thing you could do with your money? You've got some money. You're not going to use it right now. You want to use it maybe in a year, three years, five years from now. How do I get that money into the future? What's the safest possible thing? I just want to make sure I have that money five years from now. What's the safest possible thing I could do? Well, I could put it under my mattress. If I put it under my mattress, what's going to happen? My house could burn down. The money could deteriorate because of inflation. It's not really the safest thing to do with my money because there's a little bit of risk, right? I might lose the money. I might forget. I might move my bed. I could put it in a bank. OK, if I put it in a bank, what could happen to the bank? The bank might get robbed. OK, if the bank got robbed, would my money be gone? Well, not really, my money's insured. My money's insured by whom? My money's insured by the federal government. Maybe they'll pay back my money. But I'm a little bit worried about the bank. Maybe I can put my money in gold. Maybe gold's the safest thing to do. But gold goes way up in price, and then it goes way down in price. And I don't want to three years from now, five years from now when I need that money, I'm hoping that gold hasn't gone down in price. Gold is a volatile commodity. That's certainly not the safest thing to do. But let's think back to the bank. If I had put my money in the bank and the bank got robbed, at least in the US I would have Federal Deposit Insurance. And so I would go to the FDIC, and they would give me my money back. But where's the FDIC getting their money? The FDIC is backed up by the US Treasury, so why don't we get rid of all the middlemen? Why don't we get rid of the bankers and the FDIC just go straight to a US treasury bond? The US Treasury bond is really the safest thing that I could possibly do with my money. That's thinking about risk from a default standpoint, right? The United States government is not going to default on their bonds, at least anytime soon, at least while the US is the reserve currency of the world. What could they do if they run out of money? They could just print more. And so as long as the US government can print more money, they're probably not going to default on their treasury. Now, if they printed money for a long time, maybe 10 years from now, we'd be talking about a different scenario, where the US wasn't the reserve currency of the world. But at least in the short term, the US treasury can print money to get out of its debt. And that means, in a sense, that the US treasuries are really backed by their ability to collect future taxes from US citizens in the future. And given the strength of the US economy and our position as the reserve currency of the world, US treasuries really are the safest possible thing that I can do with my money right now. So that gives us a floor. That's a really good thing. The fact that we've got the US Treasury out there as the safest possible thing I can do with my money, that gives us a baseline, a foundation, a floor to start thinking about risk. Because really any rate of return, whether I'm thinking about buying General Electric bonds or I'm thinking about buying Facebook stock, what I expect to earn, what rate of return I expect to earn on an asset with that kind of risk, should at least be the risk-free rate. That's the foundation, the floor, the very bottom. | should at least earn that. Because I'm not going to earn that on Facebook stock, why not just put my money in treasury bonds? So the risk-free rate form's our floor, our foundation. Anything that's riskier than that, which is anything else, is going to have to earn some risk premium. And what we're going to talk today is what kind of risk premium-- in all of future lessons this week, we're going to talk about what kinds of risk premiums to put on assets with different kinds of risk. Let's take a look at historical rates and think about what risk-free rates often look like. In the US, for the last roughly 100, 120 years, if we look at this graph, we can see that US Treasury rates-- these are the rates on long term, about 10-year constant maturity treasuries-- are around 5% or 6%. That's kind of right around here. Then they went way up in the inflation that we had in the '70s and early '80s. And then they've come way back down as the Fed has sort of tried to tame that inflation. If I give the sort of a long run historical average, interest rates are kind of right in that zone right in there. That's around 5% or 6%, maybe up to 7%. 5% to 7% is around where risk-free rates are. What's interesting is, if I go back another 100 years and look at Treasury rates in England, where we've got some good historical rates, those rates are around 5%, 6%, 7%. If you go back to medieval Europe, where the Italian city-states were lending money to each other and we've got some decent data on historical interest rates, those interest rates were around 6%, 7%. We've got data going back to ancient Rome. What do you think Romans-- Rome actually had a relatively well-developed banking system. What were the Romans charging each other on mortgages and interest rates between private individuals on debt? They were charging each other around 7% or 8%. It's interesting that 5%, 6%, 7%, right in the middle there, seems to be about right for what people, at least during peace time, seems like a reasonable rate of return. If you go back to the lessons that we did in week one, where we said those interest rates have to compensate me for wanting to be patient-- I don't really want to be patient. But if you compensate me, I'm willing to do so. It seems all throughout the course of human history that 5%, 6%, 7%, that sort of neighborhood seems right. It feels right. I'm willing to be patient if you pay me around 6%. 6% I'm willing to do it. 3% I'm not really willing to do it. 10% seems like too good to be true. 5%, 6%, 7%, somewhere in that neighborhood seems like sort of a fundamental. That's how willing I am to sort of trade off consumption today for a promise of the future. So the risk-free rate also has sort of a yield curve to it, what financial economists call a yield curve. That means the longer maturity, the higher the rate. That kind of makes sense from a risk perspective. Rates may arise in the future, and there's more liquidity risk. I'm not sure I'm going to be able to sell something five years, 10 years. What's going to happen 20 years from now? The further you sort of look out into the future, the more that cone of uncertainty sort of expands. The more that cone of uncertainty expands, the more I'm going to charge you to be patient. So the yield curve on average tells us that the farther the maturity out, the higher the rate I'm going to take to bear that risk. To sum up risk-free rates, the risk-free rate sets the floor. Anything riskier than that has to earn some premium over the risk-free rate. Our risk-free rate is the US Treasury. That's going to be our benchmark for thinking about the bottom, the baseline, the foundation rate of return. And those rates tend to rise before the maturity of the debt.
