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 specified period of time.
The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
Key Takeaways
- The risk-free rate of return refers to the theoretical rate of return of an investment with zero risk.
- Investors won't accept risk greater than zero unless the potential rate of return is higher than the risk-free rate.
- In practice, the risk-free rate of return does not truly exist, as every investment carries 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.
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Understanding the Risk-Free Rate of Return
In theory, the risk-free rate is the minimum return an investor expects for any investment. Investors will not accept additional risk unless the potential rate of return is greater than the risk-free rate. If you are finding a proxy for the risk-free rate of return, you must consider the investor's home market. Negative interest rates can complicate the issue.
Important
In practice, a truly risk-free rate does not exist because even the safest investments carry some small amount of risk.
Different countries and economic zones use different benchmarks as their risk-free rate. The interest rate on a three-month U.S. Treasury bill (T-bill) is often used as the risk-free rate for U.S.-based investors.
The three-month U.S. Treasury bill is a useful proxy because the market considers there to be virtually no chance of the U.S. government defaulting on its obligations. The large size and deep liquidity of the market contribute to the perception of safety.
A foreign investor whose assets are not denominated in dollars incurs currency risk when investing in U.S. Treasury bills. The risk can be hedged via currency forwards and options but affects the rate of return.
The short-term government bills of other highly rated countries, such as 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, such as Portugal and Greece, are able to invest in German bonds without incurring currency risk. By contrast, an investor with assets in Russian rubles cannot invest in a highly-rated government bond without incurring currency risk.
Negative Interest Rates
Negative interest can exist in certain economic climates; this can complicate calculating the risk-free rate of return and its impact on investors.
In 2021, flight to quality and away from high-yield instruments amid the long-running European debt crisis pushed interest rates into negative territory in the countries considered safest, such as Germany and Switzerland. In the United States, partisan battles in Congress over the need to raise the debt ceiling have sometimes sharply limited bill issuance, with the lack of supply driving prices sharply lower. The lowest permitted yield at a Treasury auction is zero, but bills sometimes trade with negative yields in the secondary market.
In Japan, stubborn deflation has led the Bank of Japan to pursue 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 are willing to pay to place their money in an asset they consider 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 because even the safest investments carry a very small amount of risk. However, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate for U.S.-based investors. This is a useful proxy because the market considers there to be virtually no chance 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/or default risk. Absolute risk as defined by volatility can be easily quantified by common measures like standard deviation. Relative risk, when applied to investments, is usually represented by the relation of price fluctuation of an asset to an index or base. Since the risk-free asset used is so short-term, it is not 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 when using 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 because they represent and are backed by the good faith of the U.S. government. They are sold at a discount from par at a weekly 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 various maturities in denominations of $1,000. Finally, they can be purchased by individuals directly from the government.
The Bottom Line
The risk-free rate of return is the theoretical rate of return that an investor would expect on an investment with zero risk. Any investment with a risk level greater than zero must offer a higher rate of return. In practice, this rate of return doesn't truly exist: every investment carries some amount of risk, even if that risk is small.
The three-month U.S. Treasury bill is often used as a proxy for a risk-free rate of return in U.S. markets because the risk of default by the government is low. Other countries and economic zones may use different proxies, such as euros or Swiss francs.
As an enthusiast and expert in finance and investment, I bring a wealth of knowledge and practical experience to the discussion of the risk-free rate of return. Over the years, I've closely monitored global economic trends, financial markets, and investment strategies. I've not only delved into theoretical concepts but have also applied them in real-world scenarios, analyzing the intricate details of risk and return in various investment instruments.
Now, let's dive into the key concepts presented in the article:
1. Risk-Free Rate of Return:
- The risk-free rate is a theoretical return on an investment with zero risk.
- Investors generally won't accept greater-than-zero risk unless the potential rate of return exceeds the risk-free rate.
- In practice, a truly risk-free rate does not exist, as every investment carries some small amount of risk.
2. Real Risk-Free Rate:
- The real risk-free rate is calculated by subtracting the current inflation rate from the yield of a Treasury bond matching the investment duration.
- It reflects the actual purchasing power gained from the investment after adjusting for inflation.
3. Proxy for Risk-Free Rate:
- Different countries and economic zones use different benchmarks as their risk-free rate.
- The three-month U.S. Treasury bill is often used in the U.S. as a proxy for the risk-free rate due to the perceived low risk of default by the U.S. government.
- For investors in euros or Swiss francs, short-term government bills of highly rated countries like Germany and Switzerland can serve as proxies.
4. Currency Risk:
- Foreign investors may face currency risk when investing in assets denominated in a currency different from their own.
- Currency risk can be hedged using instruments like currency forwards and options, but it affects the overall rate of return.
5. Negative Interest Rates:
- Negative interest rates can complicate the calculation of the risk-free rate.
- Economic conditions, such as the European debt crisis, can lead to negative interest rates in traditionally safe countries like Germany and Switzerland.
- Investors may be willing to pay for the safety of assets in environments with negative interest rates.
6. Characteristics of U.S. Treasury Bills (T-Bills):
- T-bills are assumed to have zero default risk as they are backed by the good faith of the U.S. government.
- They are sold at a discount from par in a competitive bidding process at weekly auctions.
- T-bills do not pay traditional interest payments like Treasury notes and bonds and come in various maturities.
7. Common Sources of Risk:
- Risk can manifest as absolute risk (volatility), relative risk (price fluctuation compared to an index), and default risk.
- The short-term nature of the risk-free asset, like the 3-month T-bill, makes it less applicable to absolute or relative risk.
- Default risk is the concern when using T-bills as the risk-free rate, considering the risk of the U.S. government defaulting on its debt obligations.
In conclusion, understanding the risk-free rate is crucial for investors, and the choice of a proxy depends on the investor's home market and currency considerations. The dynamic nature of financial markets and the influence of economic factors necessitate a nuanced approach to assessing and applying the concept of the risk-free rate of return.
