What is the Risk-Free Rate of Return?
Risk-free rate is the minimum rate of return that is expected on investment with zero risks by the investor, which, in general, is the government bonds of well-developed countries; which are either US treasury bonds or German government bonds. It is the hypothetical rate of return, in practice, it does not exist because every investment has a certain amount of risk.
Risk-Free Rate of Return Reflects 3 Components
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For eg:
Source: Risk-Free Rate (wallstreetmojo.com)
- Inflation:- The expected rate of inflation over the term of the risk-free investment;
- Rental Rate:- It is the real return over the investment period for lending the funds.
- Maturity risk or Investment risk:Investment Risk:Investment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more It is the risk that is related to the investment’s principal market value, i.e., it can be a rise or fall during the period to maturity as a function of changes in the general level of interest rates.
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For eg:
Source: Risk-Free Rate (wallstreetmojo.com)
US Treasury Bills
T bills are the short term obligation issued by the US Government. These are issued for one year or less than a year. These are the safest investment as they are backed by the US government. T bills carry a zero default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more as they are fully guaranteed and credit by the US government and the Department of the treasury.
Funds generated from selling Treasury bills, the government uses those funds for various public projects such as highway & schools. There are so many factors that influence treasury bills prices like monetary policy, macroeconomic conditions, and supply& demand for the treasury. Longer treasury bills tend to have higher returns, but normally T bill’sT Bill'sTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity.read more maturity lies between few days to 12 months.
Calculation of Risk-Free Rate
- Most of the time, the calculation of the risk-free rateCalculation Of The Risk-free RateA risk-free rate of return formula calculates the interest rate that investors expect to earn on investment with zero risks, especially default and reinvestment risks. It is usually closer to the base rate of a central bank and may differ for different investors.read more of return depends on the time period that is under evaluation. Suppose the time period is for one year or less than one year than one should go for the most comparable government security, i.e., Treasury Bills. For example, if the treasury bill quote is .389, then the risk-free rate is .39%.
- If the time duration is in between one year to 10 years, then one should look for Treasury Note. For Example: If the Treasury noteThe Treasury NoteTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly.read more quote is .704, then the calculation of the risk-free rate will be 0.7%
- Suppose the time period is more than one year than one should go for Treasury Bond. For example, if the current quote is 7.09, then the calculation of the risk-free rate of return would be 7.09%.
Risk-Free Rate in CAPM
While calculating the cost of equity using CAPMCost Of Equity Using CAPMCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more, a Risk-free rate is used, which influences a business weighted average cost of capital. Calculation of cost of capital takes place by using the Capital Asset Pricing ModelUsing The Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM).
CAPM describes the relationship between systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more and expected return. It determines the fairest price for the investment based on risk, potential returns & other factors.
CAPM Formula & Risk-Free Return
ra = rrf + Ba (rm-rrf)
- rrf = the rate of return for a risk-free security
- rm = the broad market’s expected rate of return
CAPM Formula Example
If the risk-free rate is 7%, the market return is 12%, and the stock’s beta is 2, then the expected return on the stock would be:
Re = 7% + 2 (12% – 7%) = 17%
In the above CAPM example, the risk-free rate is 7%, and the market return is 12%, so the risk premium is 5% (12%-7%), and the expected return is 17%. The capital asset pricing model helps to calculate the required rate of returnCalculate The Required Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more on equity based on how risky that investment is when compared to a totally risk-free.
Summary
- A risk-free rate is a rate of return of an investment with zero risks.
- It is the hypothetical rate of return; in practice, it does not exist because every investment is having a certain amount of risk.
- US treasury bills consider as risk-free assets or investment as they are fully backed by the US government.
- In the cost of Equity, a Risk-free rate is used for CAPM calculation.
- Calculation of cost of capital takes place by using the Capital Asset Pricing ModelUsing The Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM).
- CAPM describes the relationship between systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more and expected return
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