Investing is the holy grail of financial freedom. You save enough from your primary source of income to invest in an instrument that can provide adequate returns to multiply the invested amount over time. The compounding effect creates a chain reaction that can provide you with enough capital over time. However, investing is not easy as the market and the rate of return for almost every investment instrument are highly affected by external factors.
These factors, such as economic growth, GDP, geographical events, negative/positive news etc., can force the rate of return to fluctuate and result in decreasing returns. For an investor, the goal is to invest in a risk-free instrument, which is explained through the risk-free rate of return.
What is the risk-free rate of return?
The risk-free rate of return is a theoretical number within the capital markets that pertains to an investment that provides guaranteed returns with negligible or zero risk. In the financial market, a risk-free rate of return is attributed to the interest payments or the rate of return received by an investor on the money invested in a risk-free financial instrument over a specific period.
Although investors have searched for years to find an instrument that has a risk-free rate of return, the theoretical principle is yet to be proven. For now, a risk-free rate of return does not exist, as there are no investment instruments that carry zero risk. However, Treasury Bills are the only instruments that are considered close to earning a risk-free rate of return. It is because the government backs them and the probability of the government defaulting on interest payments is almost negligible.
Understanding Risk-Free Rate of Return
The basic goal before choosing an investment is to earn a good rate of return with a negligible risk factor. However, there may be some investments that come with lesser risk than others; it is not possible for a financial instrument that trades in the free market to come with zero risk.
The risk-free rate of return reflects three core components theoretically:
- Inflation: Inflation means a considerable and persistent rise in the general level of prices of goods and services in an economy over time. Here, it is the inflation rate throughout holding the risk free investment.
- Rental Rate: Rental rate is the actual realised rate of return on the investment. Here, it is the rate of return of the risk-free investment that the investor gets regularly without default.
- Investment Risk: It is the risk that comes with every investment tool and can force a decline in the value. Here, the investment risk is reflected as zero, where the investor cannot make losses.
Calculation of Risk-Free Return
Generally, a basic principle to calculate the risk-free rate of return is to use the investment time in the risk-free instrument. However, one of the most respected financial models to calculate risk-free returns is the Capital Asset Pricing Model (CAPM). It calculates the risk-free rate of return by equating the returns on the security to the sum of the risk premium and risk-free return. The Capital Asset Pricing Model formula is as follows:
Ra = Rf + [Ba x (Rm -Rf)]
where Ra = return on a security
Ba = beta of a security
Rf = risk-free rate
- The risk premium is calculated as the difference between market return and risk-free return as stated in the formula as Rm – Rf.
- The beta of a security is the measure of the volatility or systematic risk attached to a security or an investment tool. In the CAPM model, the beta explains the relationship between expected returns for assets and the associated systematic risk.
Example of Risk-Free Return
Risk-free returns are almost impossible to find as there is risk attached to every single financial instrument. However, for an investor wanting to replicate the theoretical number of a risk-free rate of return, the closest example is Treasury Bills. Treasury bills are issued by the government and mature within one year. These bills do not offer a fixed interest payment but offer returns at maturity by allowing investors to buy the bills at a lesser rate than the face value.
Since they are issued by the government they carry almost negligible risk, there are very less chances of the government having no money to provide interest to the investors. For example, you can buy a treasury bill with Rs 100 face value at Rs 98 and get a return based on the difference between the face value and the issue price.
Final Word
A risk-free rate of return is a theoretical number that explains the rate at which an investor is provided interest payments on the money invested in a risk-free investment tool. The theory imagines an ideal process to realise guaranteed returns with zero risk. However, as there is no financial instrument with zero risk, an investor needs to evaluate various instruments on their risk profile before investing. Identifying the investment horizon is one of the most important aspects of finding the closest investment instruments to earn a risk-free rate of return.
FAQs
The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
What is the risk-free rate of return generally considered? ›
The risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to be equal to the interest paid on a 10-year highly rated government Treasury note, generally the safest investment an investor can make.
What is the risk-free rate of return benchmark? ›
The risk-free rate of return is used as a benchmark when evaluating investments. It helps to determine whether they're worth pursuing. It's also important because it allows us to compare different investments with each other. We can then make informed decisions about which ones we should pursue first.
What is the risk-free rate in the US? ›
The risk-free rate is the rate of return of an investment with no risk of loss. Most often, either the current Treasury bill, or T-bill, rate or long-term government bond yield are used as the risk-free rate. T-bills are considered nearly free of default risk because they are fully backed by the U.S. government.
What is the risk-free rate for CAPM? ›
The risk-free rate signals an investment that has no risk; the investor will not lose money. The rate is the main component of many famous theories, such as the capital asset pricing model (CAPM), modern portfolio theory (MPT), and the Black-Scholes model.
What is an example of a real risk-free rate of return? ›
If you are in for the short-term, then you can stick to the 3-month Treasury bill. Let's look at an example. Imagine that you want to invest in a 10-years Treasury Bond that yields 3% for the duration. In that case, the risk-free rate of return would be that 3%, adjusted to inflation.
What is the meaning of risk-free? ›
adjective. thought to be devoid of risk. synonyms: riskless, unhazardous. safe. free from danger or the risk of harm.
What is the rate of return in excess of the risk-free rate? ›
In order to calculate excess returns, subtract the returns on a risk-free investment from the returns on an investment and that will equal the excess returns. The formula is: Excess returns = Returns on investment - Returns on a risk-free investment.
What is the 5 year risk-free rate of return? ›
Basic Info
5 Year Treasury Rate is at 3.41%, compared to 3.43% the previous market day and 4.45% last year. This is lower than the long term average of 5.53%.
What is risk-free benchmark rate? ›
The (near) risk-free benchmark rate (RFR) for the Australian dollar is the cash rate. It is administered by the Reserve Bank and calculated as the weighted average interest rate on unsecured overnight loans between banks. The cash rate is best known as the Reserve Bank Board's operational target for monetary policy.
Here are the best low-risk investments in 2024:
- High-yield savings accounts.
- Money market funds.
- Short-term certificates of deposit.
- Series I savings bonds.
- Treasury bills, notes, bonds and TIPS.
- Corporate bonds.
- Dividend-paying stocks.
- Preferred stocks.
High-risk investments may offer the chance of higher returns than other investments might produce, but they put your money at higher risk. This means that if things go well, high-risk investments can produce high returns. But if things go badly, you could lose all of the money you invested.
What is the rate of return risk? ›
Profit rate risk or rate of return risk is the risk that the Group will incur a financial loss as a result of a mismatch in the profit rate on the Group's assets and unrestricted investment accounts.
What is the name of the US risk-free rate? ›
10 Year Treasury Rate (I:10YTCMR)
The 10 year treasury yield is included on the longer end of the yield curve. Many analysts will use the 10 year yield as the "risk free" rate when valuing the markets or an individual security.
Can a risk-free rate of return be negative? ›
The correct interpretation is that the risk-free rate could be either positive or negative and in practice the sign of the expected risk-free rate is an institutional convention – this is analogous to the argument that Tobin makes on page 17 of his book Money, Credit and Capital.
What is the 10 year risk-free rate of return? ›
Basic Info. 10 Year Treasury Rate is at 3.68%, compared to 3.65% the previous market day and 4.25% last year. This is lower than the long term average of 4.25%. The 10 Year Treasury Rate is the yield received for investing in a US government issued treasury security that has a maturity of 10 year.
What should my risk-free rate be? ›
The risk-free rate should ideally match the duration of the forecast period of the cash flows, however, the limited liquidity and data for the longest maturity government-issued bonds have made the current yield on 10-year US treasury notes the preferred risk-free rate proxy in the U.S.
Why do we use 10 year Treasury as risk-free rate? ›
Treasury securities are considered safer investments relative to stocks because they are backed by the U.S. government. Bond prices and yields move in opposite directions, which means that falling prices boost yields and rising prices lower yields.
