As an investor, there are many terms and phrases that you need to be aware of. Irrespective of your risk profile and your investment horizon, staying updated about the jargon involved in investing and in the different types of investment options is a good practice. At this juncture, there’s one term that many investors have often heard of but have no clear idea what it’s actually all about. This term is the risk-free rate of return.
If you haven’t heard of it or understood it fully, you probably have a lot of questions swarming around in your head.
What is the risk-free rate of return?
Does it really exist?
What does it signify?
What investments is the risk-free return applicable to?
To understand all this and more, it’s best to begin at the basics and answer the fundamental question: What is the risk-free rate of return? So, let’s get started.
What is the risk-free rate of return?
Theoretically, the risk-free rate of return is the minimum rate of return that can be expected or earned by the investor from an investment that bears zero risk. This is considered by some experts as a merely theoretical concept because in practice, there’s no investment that comes with zero risk. All investments carry some degree of risk, however negligible. This means that it may not practically be possible for an investor to earn risk-free returns.
Nevertheless, the term is widely used to refer to the returns obtained from specific investment options, such as the US treasury bonds or the German government bonds. The reasoning behind this is that with regard to developed countries like the USA and Germany, the risk associated with government-backed bonds is negligible enough for the earnings thereon to be considered as risk-free returns.
What does the risk-free rate of return signify?
Typically, the risk-free rate reflects three main components, namely the inflation in the country, the rental rate, and the investment risk associated with an investment option. Let’s take a closer look at these components.
- Inflation: Inflation refers to the increase in the prices of goods and services with time. In other words, it’s the decrease in purchasing power across a given period. With regard to risk-free returns, inflation is considered for the tenure of the investment option in question.
- Rental rate: This term refers to the rate of the actual or the real returns associated with lending the funds over the investment period.
- Investment risk: Also known as the maturity risk, this is the risk associated with the principal market value of the investment. It can either increase or decrease during investment tenure due to the changes in the levels of interest rates prevailing in the economy.
What does the risk-free rate of returns mean for investors?
Well, you now know the answer to the basic question: What is the risk-free rate of return? But as an investor, it’s likely that you have more questions related to how this rate affects investors like you. And that’s a very valid concern. So, let’s take a look at what the risk-free rate means for investors.
Given that risk-free returns are associated with investments that supposedly carry zero level of risk, it naturally means that any other investment option, which carries more than zero risk, must offer returns at a higher rate to attract investors. In other words, the risk-free rate of return is the minimum rate of returns that you can expect from investments in the market.
The risk-free rate thus acts as a basis for calculating other rates, such as the cost of equity, which is calculated by adding a risk premium to the rate of risk-free returns prevailing in the market. This risk premium accounts for the additional element of risk associated with other investment options.
Likewise, the risk-free interest rate can also be used to compute the cost of debt. Here, a default spread is added to the risk-free rate to account for the increased risk. This spread depends on the level of credit risk associated with the issuer of the debt instrument.
Now that you know what the risk-free rate of return is, you can consider this metric too before you make your investment decisions. Keep in mind that the risk-free rate is not a constant number. It keeps changing based on various microeconomic and macroeconomic factors. So, remember to stay updated about the prevailing risk-free rate.