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 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

    Risk-free return is the theoretical return attributed to an investment ...
  2. Cost Of Equity

    The cost of equity is the rate of return required on an investment ...
  3. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model is a model that describes the relationship ...
  4. Treasury Bond - T-Bond

    A treasury bond is a marketable, fixed-interest U.S. government ...
  5. Uncovered Interest Rate Parity ...

    Uncovered interest rate parity states that the difference in ...
  6. Low Interest Rate Environment

    A low interest rate environment is when the risk-free rate of ...
Related Articles
  1. 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 ...
  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. 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.
  5. 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.
  6. 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.
  7. Trading

    Forward Contracts: The Foundation Of All Derivatives

    An investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward contract to generate risk-free returns.
  8. Financial Advisor

    Measure Your Portfolio's Performance

    Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
  9. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
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 does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  3. The real rate of return is the amount of interest earned over and above the?

    The real rate of return is the amount of interest earned over and above the: a. discount rate. b. tax rate. c. inflation ... Read Answer >>
  4. How do you calculate costs of capital when budgeting new projects?

    Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
Trading Center