A risk-free rate return is a theoretical interest rate that an investment is expected to yield if it has no risk whatsoever. Often, the yield on government bonds of stable countries, like U.S. Treasury Bills, is used as the risk-free rate as it is assumed that the government will never default on its payments. However, it is essential to note that these are still subject to some risk, for example, inflation risk. Risk-free rate is a critical concept in finance, used to calculate the expected return on an investment considering the risk involved.
1. How is risk-free rate used in investment decisions?
Risk-free rate is used in the Capital Asset Pricing Model (CAPM) to determine an investment’s expected return considering the risk involved. An investment should offer a return higher than the risk-free rate to justify the risk.
2. Does risk-free rate remain constant?
Want More Financial Tips?
No, the risk-free rate may vary over time based on economic conditions and monetary policy changes. For instance, when a central bank cuts interest rates, the yield on government bonds (risk-free rate) typically decreases.
3. Why is the U.S. Treasury Bill often seen as the risk-free rate?
U.S. Treasury Bills are often considered as the risk-free rate because they are backed by the U.S. government, which is viewed as a reliable payer, making their default risk nearly nonexistent.
4. Is there a real risk-free investment?
While U.S. government bonds, for instance, are considered nearly risk-free, no investment is entirely without risk. Even these bonds carry some level of risk, for example, the inflation risk.
5. What is the difference between risk-free rate and risky rate?
While the risk-free rate is the return expected from an investment with zero risk, the risky rate is the return expected from an investment that carries a degree of risk. The latter should be higher to compensate for the additional risk taken on by investors.