What security is typically used to approximate the risk-free rate?

The typical security used to approximate the risk-free rate is indeed the yield on U.S. Treasury bonds, specifically due to their reputation for safety and reliability. U.S. Treasury securities are backed by the full faith and credit of the U.S. government, making them virtually free of credit risk. Among various maturities, the yield on a 20-year U.S. Treasury bond is commonly referenced because it offers a balance between investment horizon and the impact of economic factors, such as inflation and interest rate changes, over a significant period of time.

Using Treasury bonds allows analysts and investors to estimate a risk-free rate that reflects a long-term, stable investment without the variability associated with other securities. While other potential options like corporate bonds and municipal bonds carry default risk and thus provide higher yields due to the associated risks, they do not accurately represent the risk-free rate used in financial models and calculations. Treasury bonds' ability to serve as a benchmark for the risk-free rate is a cornerstone in various valuation methods and financial analyses.