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-Free Return

    The theoretical rate of return attributed to an investment with ...
  2. Capital Allocation Line - CAL

    A line created in a graph of all possible combinations of risky ...
  3. Risk Premium

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

    A theory in which the interest rate differential between two ...
  5. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected ...
  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

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  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

    What's the Option-Adjusted Spread?

    The option-adjusted spread, or OAS, measures a fixed-income security rate’s spread and the risk-free rate of return that’s adjusted to account for an embedded option.
  7. Investing

    More Ways to Evaluate Portfolio Performance

    The Jensen measure is another tool investors use to include risk when measuring portfolio performance.
  8. Insights

    How Interest Rates Affect The Stock Market

    Whether you're buying lunch, a home or a stock, you're influenced by interest rates.
  9. Investing

    How Interest Rates Affect Property Values

    When interest rates fall, real estate prices tend to increase. Why? Find out here.
  10. Investing

    Are U.S. Treasuries Still Riskless?

    Many investors are now asking if treasuries have become a risk asset as negative rates sweep the globe.
RELATED FAQS
  1. How is the risk-free rate determined when calculating market risk premium?

    Learn how the risk-free rate is used in the calculation of the market risk premium, and understand why T-bills provide the ... Read Answer >>
  2. How accurate is the equity risk premium in evaluating a stock?

    Learn about the drawbacks of using the equity risk premium to evaluate a stock, and understand how it is calculated using ... Read Answer >>
  3. What is the breakdown of subjects covered on the Series 6 exam?

    Learn about the risk-return tradeoff for investing in stocks versus low-risk Treasurys and bonds, and understand the types ... Read Answer >>
  4. 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 >>
  5. 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 >>
  6. What is the historical market risk premium?

    Learn what the historical market risk premium is and the different figures that result from an analyst's choice of calculations ... Read Answer >>
Hot Definitions
  1. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  2. Quadruple Witching

    The expiration date of various stock index futures, stock index options, stock options and single stock futures. All stock ...
  3. Co-pay

    A type of insurance policy where the insured pays a specified amount of out-of-pocket expenses for health-care services such ...
  4. Protectionism

    Government actions and policies that restrict or restrain international trade, often done with the intent of protecting local ...
  5. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  6. Demonetization

    Demonetization is the act of stripping a currency unit of its status as legal tender and is necessary whenever there is a ...
Trading Center