What Is the Risk-Free Rate of Return, and Does It Really Exist?

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.

The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.

Understanding the Risk-Free Rate of Return

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

In practice, however, a truly 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 (T-bill) is often used as the risk-free rate for U.S.-based investors.

The three-month U.S. Treasury bill is a useful proxy because the market considers there to be virtually no chance of the U.S. 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 affects 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 (EUR) or Swiss francs (CHF). 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.

Why Is the U.S. 3-Month T-Bill Used as the Risk-Free Rate?

There can never be a truly risk-free rate because even the safest investments carry a very small amount of risk. However, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate for U.S.-based investors. This is a useful proxy because the market considers there to be virtually no chance of the U.S. government defaulting on its obligations. The large size and deep liquidity of the market contribute to the perception of safety.

What Are the Common Sources of Risk?

Risk can manifest itself as absolute risk, relative risk, and/or default risk. Absolute risk as defined by volatility can be easily quantified by common measures like standard deviation. Relative risk, when applied to investments, is usually represented by the relation of price fluctuation of an asset to an index or base. Since the risk-free asset used is so short-term, it is not applicable to either absolute or relative risk. Default risk, which, in this case, is the risk that the U.S. government would default on its debt obligations, is the risk that applies when using the 3-month T-bill as the risk-free rate.

What Are the Characteristics of the U.S. Treasury Bills (T-Bills)?

Treasury bills (T-bills) are assumed to have zero default risk because they represent and are backed by the good faith of the U.S. government. They are sold at a discount from par at a weekly auction in a competitive bidding process. They don't pay traditional interest payments like their cousins, the Treasury notes and Treasury bonds, and are sold in various maturities in denominations of $1,000. Finally, they can be purchased by individuals directly from the government.