In theory, the risk-free rate is the minimum return an investor expects for “delaying his consumption”. The investor will not accept any additional risk unless the potential rate of return is greater than the risk-free rate. Usually the government bond rate is used as the Risk free Rate. This raises several questions – which government, and what tenure? What if the government defaults? For instance, Greece has defaulted on its debt in the past.
To solve these, we need to follow a few rules
1. You can only use a developed country government bond rate that has a very strong economy and virtually no risk of default. This leaves us with very few options – US, UK, Germany, Japan etc.
Usually the US Government 10 Year Treasury Bond Rate should be used for most calculations. This is true even if the company is from India. Because from the perspective of a global investor, Indian Government bonds are not risk free.
2. You will choose the lowest available rate. The Italian Government Bond rate is higher than German Government Bond Rate since Italy is a weaker economy. So, even for an Italian Company, you will use the German Bond rate, even though both are denominated in Euros.
3. You will convert the risk free rate to the reporting currency. An Indian Company will be reporting in INR. So you can’t directly use the US Treasury Risk free rate. You need to adjust it for relative inflation in India vs US. The formula would be – Rf (INR) = Rf (USD) x Inflation (India)/ Inflation (US)