What Is The Risk-Free Rate?
The risk free rate is the return that could be received from an investment that requires no risk. The current yields on U.S. Treasury bills, “T-Bills”, are commonly used by investors gauging the risk free rate.
Risk Free Rate Vs. “Real” Risk Free Rate
The risk free rate can be taken one step further by also accounting for inflation rates. By subtracting the inflationary rate from the risk free rate, you get the “real” risk free rate.
What Are The Applications Of The Risk Free Rate
As stated before, the risk free rate is the expected return investors can expect from an investment that requires no risk. So, when taking on risk, investors should receive greater returns than they would expect to receive via the risk free rate. This theory is quantified via the market risk premium. Additional applications of the risk free rate come the capital asset pricing model (CAPM). CAPM uses the risk free rate to calculate the cost of equity by quantifying the risk of an asset.
What To Use As Risk Free Rate
United States Government-backed debt securities, such as Treasury bills, are most commonly used as the risk free rate. While it is true that no investment comes with absolutely zero risk, there is almost zero chance of the United States defaulting on its debt.
Example of Risk Free Rate
A specific example of the risk-free rate can be the yield on a 10-year US Treasury bond. US Treasury bonds are considered to be virtually risk-free because they are backed by the full faith and credit of the US government.
For instance, let’s assume that the current yield on a 10-year US Treasury bond is 2.5%. This means that investors are willing to lend money to the US government for 10 years and receive a return of 2.5% per year, with no risk of default. This 2.5% yield represents the risk-free rate.
The risk-free rate is an essential component of many financial models, such as the capital asset pricing model (CAPM), which is used to estimate the expected return on an investment. The risk-free rate serves as a benchmark against which the expected returns of other investments are compared.
In practice, the risk-free rate can vary over time and may differ across different countries and currencies. Central banks also play a crucial role in determining the risk-free rate by setting monetary policy, which can affect interest rates and bond yields.
Investors should carefully consider the risk-free rate when making investment decisions, as it represents the minimum return that they can expect to receive without taking on any risk.
