What is the risk-free rate of return?

The risk-free rate of return is the theoretical rate of return on an investment with zero risk. The risk-free rate represents the interest that 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 on the Treasury bond that matches the duration of your investment.

Key takeaways

  • Risk-free rate of return refers to the theoretical rate of return on an investment with zero risk.
  • In practice, the risk-free rate of return doesn’t really 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 Treasury bond yield that matches the duration of your investment.

Understanding the risk-free rate of return

In theory, the risk-free rate is the minimum return that an investor expects from any investment because they will not accept additional risks unless the potential rate of return is greater than the risk-free rate. Determining a proxy for the risk-free rate of return for a given situation should consider the investor’s local market, while negative interest rates can compound the problem.

In practice, however, there is no truly risk-free rate because even the safest investments carry very little risk. Therefore, the interest rate on a three-month US Treasury bill (T-bill) is often used as the risk-free rate for US-based investors.

The three-month US Treasury bill is a useful substitute because the market believes there is virtually no chance that the US government will default on its obligations. The large size and deep liquidity of the market contribute to the perception of security. However, a foreign investor whose assets are not denominated in dollars incurs currency risk when investing in United States Treasury bills. Risk can be hedged through options and currency forward contracts, but it affects the rate of return.

Short-term government bills from other highly rated countries, such as Germany and Switzerland, offer a risk-free exchange rate for investors with assets in euros (EUR) or Swiss francs (CHF). Investors based in lower-rated countries within the eurozone, such as Portugal and Greece, can invest in German bonds without incurring currency risk. In contrast, an investor with assets in Russian rubles cannot invest in a highly rated government bond without incurring currency risk.

Negative interest rates

The flight to quality and away from high yield instruments amid the protracted European debt crisis has pushed interest rates into negative territory in countries deemed safer, such as Germany and Switzerland. In the United States, partisan battles in Congress over the need to increase the debt ceiling have at times drastically limited the issuance of banknotes, and the lack of supply has caused prices to drop dramatically. The lowest yield allowed in a Treasury auction is zero, but bills are sometimes traded with negative returns on the secondary market.

And in Japan, stubborn deflation has prompted 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 put their money in an asset that they consider safe.

Why is the US 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 US Treasury bill is often used as the risk-free rate for US-based investors. This is a useful proxy because the market considers that there is virtually no chance for the US government to default on its obligations. The large size and deep liquidity of the market contribute to the perception of security.

What are the common sources of risk?

Risk can manifest itself as absolute risk, relative risk, and / or default risk. The absolute risk defined by volatility can be easily quantified using common measures such as standard deviation. Relative risk, when applied to investments, is usually represented by the relationship between an asset’s price fluctuation and an index or basis. 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 US government will default on its debt obligations, is the risk that is applied when using the 3-month treasury bill as the risk-free rate. .

What are the characteristics of the US Treasury bills (T-Bills)?

Treasury bills (Treasury bills) are assumed to have zero default risk because they represent and are backed by the good faith of the US government. They are sold at a discount from face value at a weekly auction in a bidding process. competitive. They do not pay traditional interest payments like their cousins, Treasury notes and Treasury bills, and are sold in various maturities in denominations of $ 1,000. Finally, individuals can buy them directly from the government.

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