What is a key observable factor in estimating the risk-free rate?

The yield on short maturity T-bills is considered a key observable factor in estimating the risk-free rate because Treasury bills are regarded as one of the safest investments available. They are backed by the full faith and credit of the U.S. government, which effectively eliminates the risk of default. The yield on these bills reflects the return investors require for taking on the minimal risk associated with holding Treasuries.

When investors look for a baseline rate of return that is free from credit and liquidity risk, they often refer to T-bill yields. The short maturity aspect is crucial, as it reflects the current economic environment and interest rate conditions. Additionally, since T-bills are usually sold at a discount and do not pay periodic interest, their yield is straightforward to calculate and provides a clear representation of the expected return when no risk is taken.

Other options, while relevant in the broader context of finance, do not serve as direct measures of the risk-free rate. The expected market return reflects what investors anticipate gaining from the market, which includes risk and is not risk-free. Historical returns capture past data, but they do not effectively project current or future risk-free rates. The market risk premium indicates the excess return expected by investors for taking on additional risk over a risk