Risk-Free Rate of Return

What Is the Risk-Free Rate of Return?

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 predetermined period of time.

The purported "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.

Understanding the Risk-Free Rate of Return

In theory, the risk-free rate is the base return an investor expects for any investment since they won't accept additional risk except if the potential rate of return is greater than the risk-free rate. Determination of a proxy for the risk-free rate of return for a given situation must think about the investor's home market, while negative interest rates can complicate the issue.

In practice, in any case, a truly risk-free rate doesn't exist since even the safest investments carry a tiny amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill (T-bill) is often utilized as the risk-free rate for U.S.- based investors.

The three-month U.S. Treasury bill is a valuable proxy in light of the fact that the market believes there to be virtually no possibility of the U.S. government defaulting on its obligations. The large size and deep liquidity of the market contribute to the perception of safety. Nonetheless, a foreign investor whose assets are not denominated in dollars causes currency risk while investing in U.S. Treasury bills. The risk can be hedged by means of currency forwards and options but affects the rate of return.

The short-term government bills of other highly rated countries, for example, Germany and Switzerland, offer a risk-free rate proxy for investors with assets in euros (EUR) or Swiss francs (CHF). Investors based in less highly rated countries that are within the eurozone, like Portugal and Greece, are able to invest in German bonds without bringing about currency risk. Conversely, an investor with assets in Russian rubles cannot invest in a highly rated government bond without causing currency risk.

Negative Interest Rates

Flight to quality and away from high-yield instruments in the midst of the long-running European debt crisis has pushed interest rates into negative territory in the countries considered safest, like Germany and Switzerland. In the United States, partisan battles in Congress over the need to raise the debt ceiling have sometimes strongly limited bill issuance, with the lack of supply driving prices pointedly lower. The lowest permitted yield at a Treasury auction is zero, but bills sometimes trade with negative yields in the secondary market.

What's more, in Japan, stubborn deflation has driven the Bank of Japan to seek after a policy of ultra-low, and sometimes negative, interest rates to stimulate the economy. Negative interest rates essentially push the concept of risk-free return to the extreme; investors will pay to place their money in an asset they think about safe.

Why Is the U.S. 3-Month T-Bill Used as the Risk-Free Rate?

There can never be a truly risk-free rate since even the safest investments carry a tiny amount of risk. Nonetheless, the interest rate on a three-month U.S. Treasury bill is often utilized as the risk-free rate for U.S.- based investors. This is a valuable proxy on the grounds that the market believes there to be virtually no possibility of the U.S. government defaulting on its obligations. The large size and deep liquidity of the market contribute to the perception of safety.

What Are the Common Sources of Risk?

Risk can manifest itself as absolute risk, relative risk, and additionally default risk. Absolute risk as defined by volatility can be handily quantified by common measures like standard deviation. Relative risk, when applied to investments, is typically represented by the relation of price fluctuation of an asset to an index or base. Since the risk-free asset utilized is so short-term, it isn't applicable to either absolute or relative risk. Default risk, which, in this case, is the risk that the U.S. government would default on its debt obligations, is the risk that applies while utilizing the 3-month T-bill as the risk-free rate.

What Are the Characteristics of the U.S. Treasury Bills (T-Bills)?

Treasury bills (T-bills) are assumed to have zero default risk since they represent and are backed by the honest intentions of the U.S. government. They are sold at a discount from par at a week by week auction in a competitive bidding process. They don't pay traditional interest payments like their cousins, the Treasury notes and Treasury bonds, and are sold in different maturities in denominations of $1,000. At long last, they can be purchased by people directly from the government.

Highlights

• The risk-free rate of return alludes to the theoretical rate of return of an investment with zero risk.
• There is no such thing as in practice, the risk free rate of return, as each investment conveys at least a small amount of risk.
• To calculate the real risk-free rate, subtract the inflation rate from the yield of the Treasury bond matching your investment duration.