The risk-free rate of return is the theoretical rate of return of an investment with zero risk. It represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. At its core, calculating the ‘real’ risk-free rate involves subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
Key Insights:
- The risk-free rate of return refers to the theoretical rate of return of an investment with zero risk.
- Investors will not accept additional risk unless the potential rate of return is greater than the risk-free rate.
- A truly risk-free rate of return is practically non-existent, as every investment carries at least some risk.
- To calculate the real risk-free rate, subtract the inflation rate from the yield of the Treasury bond matching your investment duration.
Understanding the Risk-Free Rate of Return
The risk-free rate serves as the minimum return investors expect for any investment. It becomes a benchmark against which risky investments are measured. Regardless of varying market conditions, if you need a proxy for the risk-free rate, consider the investor’s home market’s benchmarks. However, bear in mind that complexities arise with negative interest rates.
Important:
Practically, a truly risk-free rate doesn’t exist because even the safest investments entail some degree of risk.
Different countries use different benchmarks as their risk-free rate. For U.S.-based investors, the interest rate on a three-month U.S. Treasury bill (T-bill) proves beneficial as a proxy due to the perceived minimal default risk posed by the U.S. government. Additionally, the market’s size and liquidity amplify this perception of safety.
For foreign investors, the situation adds another layer of complexity with ‘currency risk.’ Such risk can be hedged, albeit potentially affecting route returns. Investors preferring euros or Swiss francs utilize proxies such as the short-term government bills of Germany or Switzerland, respectively. Meanwhile, less highly-rated nations within the eurozone, like Portugal or Greece, propose opportunities to invest in German bonds, consequently mitigating currency risk. In contrast, those with assets in Russian rubles face unavoidable currency risk when opting for high-rated government bonds.
Negative Interest Rates
In some economic landscapes, negative interest rates emerge as a complicating factor in calculating the risk-free rate of return. For instance, the prolonged European debt crisis and ensuing flight to quality profoundly influenced negative yield instruments, especially in countries perceived as economically safe like Germany and Switzerland. Similarly, the temporary suspension in U.S. Treasury issuance due to political stand-offs pushes bill yields downward, albeit secondary market trades occasionally harbor negative yields.
Japan casts another insightful example where persistent deflation leads the Bank of Japan to embrace policies promoting ultra-low or negative rates, aiming to stimulate economic activities. Unless approached thoughtfully, negative interest rates skew the benefit-risk equilibrium as even safe assets incur a cost.
The 3-Month U.S. Treasury Bill as Benchmark
While not inherently ‘risk-free,’ the three-month U.S. Treasury bill is a practical and commonly used proxy. Investors often bank on its near-undoubtedly minimal risk of U.S. government’s default, framed by a massively liquid market.
Typical Risks to Recognize
Risk can manifest as:
- Absolute Risk - Often defined by volatility measure, useful in quantifying potential variability in returns.
- Relative Risk - Often examined in associate to other asset’s performance or market index.
- Default Risk – For investments like the three-month U.S. Treasury bills, concerns focus on whether the U.S. government might default on its obligations.
Characteristics of U.S. Treasury Bills (T-Bills)
U.S. Treasury bills are notably considered free for defaulting risk given their endorsement by the U.S. government’s committed good faith. They undergo periodic auction, offering discount price points but no direct interest dividends akin to longer-term treasuries. Denominations typically start at $1,000 and are accessible to individual buyers directly from the U.S. government.
In Conclusion
The risk-free rate of return represents the go-to theoretical benchmark where investors harbor zero perceived risk rate expectations. Realistically, regardless of approximated safety (like the often-used three-month U.S. Treasury bill in U.S. Markets), no absolute risk-free investment exists. Countries gage their risk-free standards distinctively, contending occasionally with hurdles like negative interest rates tethered to troubled economic scenarios.
Related Terms: Real Rate of Return, Inflation Rate, Default Risk, Currency Risk, Negative Interest Rates.
References
- Deutsche Bundesbank. “Announcement of the Basic Rate of Interest as of 1 January 2021”.
- U.S. Department of Treasury. “Debt Limit”.
- Bank of Japan. “Average Interest Rates Posted at Financial Institutions by Type of Deposit”.
