What is the Risk-Free Rate of Return?

Risk-Free Rate of Return Reflects 3 Components

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  • Inflation:- The expected rate of inflation over the term of the risk-free investment;Rental Rate:- It is the real return over the investment period for lending the funds.Maturity risk or Investment risk:Investment Risk:Investment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more It is the risk related to the investment’s principal market value, i.e., it can be a rise or fall during the period to maturity as a function of changes in the general level of interest rates.

US Treasury Bills

T bills are the short term obligation issued by the US Government. These are issued for one year or less than a year. These are the safest investment as they are backed by the US government. T bills carry a zero default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more as they are fully guaranteed and credit by the US government and the Treasury Department.

Funds generated from selling Treasury bills, the government uses those funds for various public projects such as highways & schools. There are so many factors that influence treasury bills prices like monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more, macroeconomic conditions, and supply& demand for the treasury. Longer treasury bills tend to have higher returns, but normally T bill’sT Bill’sTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more maturity normally lies between few days to 12 months.

Calculation of Risk-Free Rate

  • Most of the time, the calculation of the risk-free rateCalculation Of The Risk-free RateA risk-free rate of return formula calculates the interest rate that investors expect to earn on investment with zero risks, especially default and reinvestment risks. It is usually closer to the base rate of a central bank and may differ for different investors.read more of return depends on the period under evaluation. Suppose the period is for one year or less than one year, then one should go for the most comparable government security, i.e., Treasury Bills. For example, if the treasury bill quote is .389, the risk-free rate is .39%.If the time duration is in between one year to 10 years, then one should look for Treasury Note. For Example: If the Treasury noteThe Treasury NoteTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly.read more quote is .704, then the calculation of the risk-free rate will be 0.7%Suppose the period is more than one year than one should go for Treasury BondTreasury BondA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more. For example, if the current quote is 7.09, then the risk-free rate of return calculation would be 7.09%.

Risk-Free Rate in CAPM

While calculating the cost of equity using CAPMCost Of Equity Using CAPMCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more, a Risk-free rate is used, influencing a business weighted average price of capital. Calculation of the capital cost takes place using the Capital Asset Pricing ModelUsing The Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM).

CAPM describes the relationship between systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more and expected return. It determines the fairest price for the investment based on risk, potential returns & other factors.

CAPM Formula & Risk-Free Return

ra = rrf + Ba (rm-rrf)

  • rrf = the rate of return for a risk-free securityrm = the broad market’s expected rate of return

CAPM Formula Example

If the risk-free rate is 7%, the market return is 12%, and the stock’s beta is 2, then the expected return on the stock would be:

Re = 7% + 2 (12% – 7%) = 17%

In the above CAPM example, the risk-free rate is 7%, and the market return is 12%, so the risk premium is 5% (12%-7%), and the expected return is 17%. The capital asset pricing model helps calculate the required rate of returnCalculate The Required Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more on equity based on how risky that investment is compared to risk-free.

Summary

  • A risk-free rate is a rate of return of an investment with zero risks.It is the hypothetical rate of return; in practice, it does not exist because every investment has a certain amount of risk.US treasury bills considered risk-free assets or investments as the US government fully backs them.A risk-free rate is used for CAPM calculation in the cost of equity.Calculation of the capital cost takes place by using the Capital Asset Pricing ModelUsing The Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM).CAPM describes the relationship between systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more and expected return

This article is a guide to Risk-Free rates. Here we discuss the meaning and calculation of Risk-Free Rate with Example. Here we also see how a risk-free rate affects the CAPM cost of equity. You may also take a look at our suggested articles –

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