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. Low Interest Rate Environment

    A low interest rate environment is when the risk-free rate of ...
  3. Option-Adjusted Spread (OAS)

    A measurement of the spread of a fixed-income security and the ...
  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

    How Safe Are U.S. Bonds?

    U.S. Treasury securities are often described as risk-free investments, but that is just not true.
  3. Managing Wealth

    How Interest Rates Affect Property Values

    Along with their impact on mortgages, interest rates affect capital flows, the supply and demand for capital, and an investor’s required rate of return.
  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

    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.
  6. 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.
  7. 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.
  8. Investing

    More Ways to Evaluate Portfolio Performance

    The Jensen measure is another tool investors use to include risk when measuring portfolio performance.
  9. 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.
  10. Investing

    How Interest Rates Affect Property Values

    When interest rates fall, real estate prices tend to increase. Why? Find out here.
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. 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 >>
  4. How do I calculate the equity risk premium in Excel?

    Find out how to calculate the equity risk premium for an individual security using Microsoft Excel, including how to estimate ... Read Answer >>
  5. Is market risk premium the same for all investors and investments?

    Learn about how market risk premiums are determined, how they are calculated, why some assets require higher premiums and ... Read Answer >>
  6. The real rate of return is the amount of interest earned over and above the:

    a. discount rate. b. tax rate. c. inflation rate. d. risk-free rate of return. Answer: C Since the real rate of return measures ... Read Answer >>
Hot Definitions
  1. Efficiency Ratio

    Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. Efficiency Ratios ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an ...
  4. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  5. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  6. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
Trading Center