Risk-Free Rate of Return

Risk-Free Rate of Return

Finance and investment theory consider the Risk-Free Rate of Return to be a key topic. In theory, it shows what you’d receive if you invested without risk of losing money. Therefore, an investor who backs risk-free investments expects to receive exactly what was projected without any risk that the investment will not be repaid.

Concept and Importance

Because every other investment is compared to it, the risk-free rate forms the key reference point for evaluation. People usually look for earnings that beat the risk-free return when they are taking on credit, market or liquidity risks. A risk premium is needed to handle the unpredictability found in financial markets. As a result, the risk-free rate is the lowest return an investor wants for their funds, since it only measures the time, their money is not available.

Because the risk-free rate is the basis of both CAPM and other asset valuation models, it is important for setting capital costs, discount rates and asset valuation. To avoid including risks in the valuation, financial analysts ensure that the risk-free rate is used to adjust future income.

Practical Proxy for the Risk-Free Rate

There is no investment that doesn’t have some risk in the real world. Every asset experiences uncertainty to some extent, caused by credit risk, inflation or changes in the market. That’s why professionals in finance use the rates on government securities to stand in for the risk-free rate.

Due to the fact that governments can levy taxes and print currency for themselves, so-called risk-free instruments often include bonds from countries such as the U.S. or India. Because these bonds depend on the strong reputation of the issuing government, the possibility of default is almost nil for investors.

Investors must match their security options to the kind of currency and economy in their country. For instance, the yield on U.S. Treasury bonds helps an investor in the U.S. and the investor in India would use data from Indian government bonds. Also, the age of the bond picked as a replacement should resemble that of the project or asset under analysis.

Factors Affecting the Risk-Free Rate

Though government securities are creditor risk-free, the risk-free rate keeps changing due to changes in the economy and in government decisions.

• How you can affect the risk-free rate is through monetary policy made by central banks. Setting the federal funds rate in the U.S. or the repo rate in India let central banks affect how much short-term and longer-term bonds yield. If interest rates drop, the risk-free rate usually goes down which makes both lending and investing attractive, while improving their popularity.
• When you expect inflation, your future cash flows lose value. People, who want their investment to protect them from losses caused by inflation, look for higher nominal interest rates when they anticipate inflation. That’s why higher inflation expectations result in a higher risk-free rate.

Due to how safe they seem, increased economic growth and stability, often cause government bonds to offer low-risk, low-interest rates. Should unfriendly economic conditions or financial danger arise, investors may demand extra return from bonds, raising bond yields.

Misconceptions About “Risk-Free”

We should remember that calling an investment risk-free is actually a simplification. While very secure, government bonds are unable to completely prevent all kinds of risk.

There is a risk that unanticipated inflation will cause a loss in the value of fixed-rate government bonds. Not all future money will buy the same as today’s dollars.

The interest rate increases in the market usually causes existing bonds to decrease in value. Those who have bonds before the maturity date may still lose money when they sell them.

Although stable governments rarely experience it, sometimes, these events may occur in emerging or under pressure economies. That’s why investors perceive government bonds from developing countries as being slightly higher in risk than those from more advanced nations.

Bonds purchased in currencies other than your own expose you to currency risks which can add to your overall risk.

Application of the Risk-Free Rate

Many financial applications start with the idea of the risk-free rate.

The projected cash flows that will be received in several years are taken into account by being discounted back to today’s value as if they were still usable, using a discount rate that builds in the risk-free rate. Because of this, both the concept of time value in money and the needed returns by investors are considered.

Estimation of the cost of equity and the WACC depends greatly on knowing the risk-free rate. It outlines what equity holders need to earn before facing uncertainty in the market.

The efficient frontier and proper portfolio building can be developed from the risk-free rate in today’s portfolio theory.

The Sharpe ratio uses the risk-free rate to compare a portfolio’s performance for the risk it involves. People consider the extra risk by comparing the returns of an investment to what could be earned safely at a bank.

Choosing the Appropriate Risk-Free Rate

You must choose a risk-free rate with a matching time horizon to the government security being analysed. You may use the yields on short-term treasury bills when the valuation or project covers only a short period. Projects or business assessments that are long-term prefer longer government bonds because they reflect the economy’s expected future.

When looking at the project, analysts should make sure the selected risk-free rate is matched to the project’s currency to prevent the impact of currency exchange rates.

Conclusion

The risk-free rate of return serves as a base concept for everything we do in finance when making investment decisions, assessing asset value and managing different portfolios. Most investments will always have risks, though government bonds from strong countries are still seen as a recognized reference point. People who work in financial analysis or investment management should know about the risk-free rate, the things that affect it and how it should be handled. It gives investors an idea of the basic level they can compare different risks with and they use it to predict the best result they can expect from their investments.