Loading the player...

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.

In theory, the risk-free rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate.

In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate for U.S.-based investors.

BREAKING DOWN 'Risk-Free Rate Of Return'

Determination of a proxy for the risk-free rate of return for a given situation must consider the investor's home market, while negative interest rates can complicate the issue.

Currency Risk

The three-month U.S. Treasury bill is a useful proxy because the market considers there to be virtually no chance of the government defaulting on its obligations. The large size and deep liquidity of the market contribute to the perception of safety. However, 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/or options but impacts 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 or Swiss francs. 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

Flight to quality and away from high-yield instruments amid the long-running European debt crisis has 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. And 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.

RELATED TERMS
  1. Risk-Neutral Measures

    A theoretical measure of probability derived from the assumption ...
  2. Capital Allocation Line - CAL

    A line created in a graph of all possible combinations of risky ...
  3. Low Interest Rate Environment

    A low interest rate environment is when the risk-free rate of ...
  4. Risk Premium

    The return in excess of the risk-free rate of return that an ...
  5. Interest Rate Parity

    A theory in which the interest rate differential between two ...
  6. Federally Guaranteed Obligations

    A federally guaranteed obligation is debt that is backed by the ...
Related Articles
  1. Investing

    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 ...
  2. Investing

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  3. Investing

    How Safe Are U.S. Bonds?

    U.S. Treasury securities are often described as risk-free investments, but that is just not true.
  4. Financial Advisor

    Risk-Free & 20% Return? More Like 100% Scam

    An investment that promises a risk-free return of 20% is 100% likely to be a scam.
  5. Trading

    How & Why Interest Rates Affect Futures

    There are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.
  6. Investing

    Calculating the Equity Risk Premium

    Equity risk premium is the excess expected return of a stock, or the stock market as a whole, over the risk-free rate.
  7. Investing

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
  8. Investing

    Find The Right Discount Rate Amid Post-2007 Risks

    OIS discounting has become part of standard valuation techniques, in a market in which there is more uncertainty and less proxies for the risk-free rate.
  9. Investing

    Why Risk-Free Investments Don't Exist

    We explain the risks inherent with all types of investments and why risk-free investments do not exist.
  10. Investing

    Understanding The Sharpe Ratio

    This simple ratio will tell you how much that extra return is really worth.
RELATED FAQS
  1. How is it possible for a rate to be entirely risk-free?

    Find out whether there really is such a thing as a risk-free rate of return, and learn why taking the idea of risk-free rates ... Read Answer >>
  2. How is the risk-free rate of interest used to calculate other types of interest rates ...

    Learn how the risk-free rate is used to compare the yields on bonds, and understand how T-bills are used as a proxy for the ... Read Answer >>
  3. What is the correlation between equity risk premium and risk?

    Learn about the relationship between the risk-free rate of return and the equity risk premium, and understand how the risk-free ... Read Answer >>
  4. What nations other than the U.S. have risk-free interest rates?

    Find out which countries have risk-free rates of returns. This is typically the yield on a 3-month note, and it can be negative ... Read Answer >>
  5. How do I calculate the cost of equity using Excel?

    Learn how to calculate the cost of equity in Microsoft Excel using the capital asset pricing model, or CAPM, including brief ... Read Answer >>
  6. How is the expected market return determined when calculating market risk premium?

    Find out how the expected market return rate is determined when calculating market risk premium and how these figures are ... Read Answer >>
Hot Definitions
  1. Mobile Wallet

    Mobile wallet is a virtual wallet that stores payment card information on a mobile device.
  2. Leverage

    1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. ...
  3. Trumponomics

    Trumponomics is a term for the economic policies of President Donald Trump.
  4. Universal Health Care Coverage

    An organized healthcare system that provides healthcare benefits to all persons in a specified region. Many countries, such ...
  5. Davos World Economic Forum

    The annual meeting of the World Economic Forum hosted at Davos—a small ski town in Switzerland—in January each year is among ...
  6. Smart Home

    A convenient home setup where appliances and devices can be automatically controlled remotely from anywhere in the world ...
Trading Center